The buzzword of this year – ‘credit crunch’ – has been banded about with solemnity and gloomy caution recently. At least by banks that is: insurers have generally yet to see the full impact of the squeeze, as Helen Castell, finds out.
Call it what you will, this summer’s credit crunch has had repercussions for us all. Whether it turns out to be a mega meltdown or a mere market correction, the size and shape of the iceberg beneath is as yet unknown – and such uncertainty is partly what created it in the first place.
For insurers though, the picture is even less clear. The time lag inherent in their business means that many of the effects have yet to be felt. And it won’t be until next year that even August’s banking fiascos fully filter through.
So what’s in the wings for insurers – a landslide of claims or a welcome pick-up in pricing
- Are ECAs in for a revival, how far in to the crisis are we, and where and when can we expect most of the fall-out
- Seemingly oblivious
- “Crisis – what crisis” asks Mark Cooper, managing director at TFC Brokerage. “Commodities are strong, stock markets are back and, in Asia at least, strong manufacturing orders and the robust Chinese and Indian economies are providing fundamental growth and an excellent spread of risk.”
- Effects of the crunch have been “surprisingly limited,” agrees Michel Léonard, chief economist and head of consulting, emerging markets, at Alliant Insurance. “Trade credit markets such as Brazil have remained largely unaffected, especially in terms of defaults on portfolios.” However, “much can still change”.
“The crisis currently has had little impact on most ECAs in most markets,” adds Angus Armour, managing director at Australia’s Export Finance and Insurance Corporation (Efic) in Sydney. “The crunch continues to dominate the US market, particularly high-yield and LBO markets. We haven’t seen much impact in Asia.”
Indeed, “at the moment, our market has nothing to recover from other than a very benign credit environment,” adds Will Steeds, class underwriter, war and political risks at Catlin in London.
One of the biggest difficulties in second-guessing current conditions is that no one yet knows their full nature. Add to this the inherent time-lag in insurance products and pricing and it remains too early for many insurers to predict whether a crisis will manifest in their market.
“As political risk insurance transactions generally have a three-to-six-month lead time, we are still not seeing a material impact on pricing from the US-UK credit situation,” says Price Lowenstein, president and CEO at Sovereign Risk Insurance.
“The timing is different for us than for the banking sector,” agrees Mike Holley, head of specialised credit risk solutions at Atradius. “We are not affected so much in these early stages, but to the extent that the problems feed through to the real economy we will be hit by defaults and bankruptcies. We would normally expect to see a lag of nine to 12 months before this happens.”
On the banking side however, “credit capacity is more scarce than it previously was and this is pushing up the price for some deals,” he notes.
“We should see an adjustment in premiums once business defaults start to climb,” adds Shaun Purrington, commercial director at Atradius UK and Ireland. Alliant meanwhile is using risk-returns analysis to work with underwriters to price insurance at a cost that is more aggressive than usual, Léonard says.
“Companies that have no access to the bond market still pay substantially more now and the situation could get worse should credit become really tight,” agrees Johan Schrijver, director at Atradius DSB.
However, although insurance prices are in turn rising for some sectors, the increases are appearing in pockets, don’t seem to be significant yet and in some instances are not showing at all.
Emerging markets still enjoy massive liquidity, suggesting lending spreads in those markets will not jump tremendously,” argues Lowenstein. “There will certainly be some upward movement on spreads – and corresponding political risk insurance premiums – but it remains to be seen whether this will be a few basis points or something more substantial.”
And in many cases, credit prices for emerging market sovereign debt are – after original knee-jerk price hikes – already back to normal, notes Schrijver.
“If the credit crunch results in sustained increases in credit margins then that would flow eventually into ECA pricing, but the feedback I’ve had from most of our colleagues has been that prices have yet to shift,” says Armour. “One of the benefits of the ECA line is greater consistency in price and availability.”
“The pick-up in yield in markets under the greatest stress has yet to stimulate significant shifts in capital because it’s not clear that all the sins have been revealed,” says Armour. “When that’s clearer, then the pricing dynamics might change.”
Waiting for the knock-on
For trade credit and political risk insurance specifically, the market has anticipated a hike in the price trade banks pay for their cover – but there is little evidence that this has happened yet, says Nick Robson, partner at JLT in London, and head of its credit, political and terrorism unit.
“Rather than a rapid increase in pricing, what is more likely to happen if the credit crunch deepens is a flight to quality, so weaker obligors will receive less support.”
“We are seeing a selective increase in pricing rather than a wholesale repricing of risk,” adds Steeds. “One of the main effects is probably ‘attitudinal’s rather than ‘demonstrable’s at the moment, in the sense that we are perhaps being more cautious with enquiries where we see clients trying to offload risk priced prior to the credit crunch into the insurance market, and we know that the current deals – if they are even being considered at all – are being priced at considerably higher spreads than before.”
Although some players are trying to push insurance prices up, and others are reducing their appetite for certain industry sectors, “for the trade credit guys pricing has not shown any signs of movement,” says Stephen Capon, head of country and credit risk management at Ace Global Markets in London.
“There are some signs of prices hardening, but largely this is restricted to the likes of Russia, Kazakhstan and Turkey,” he adds. “However, bank pricing for many transactions still seems to remain below levels which would achieve an acceptable transaction-specific Raroc under Basel II.”
Basel II may have made some credit tightening inevitable anyway, Capon argues. Even before the interbank problems there were signs that credit conditions for B- and BB-rated credits were tightening. “We believe this may simply have accelerated an adjustment which was likely with the advent of Basel II.”
Indeed, any increases in lending margins and insurance premiums can be viewed as a return to “realistic” levels, agrees Cooper.
Low default risk
Those areas where default risk – and therefore lending spreads and insurance premiums – could see big rises are fewer than might be expected, insurers say.
It’s early to say where the fallout will be, but many emerging market economies are regarded as safe havens, Holley says. US retail and Spanish construction though could warrant caution.
“Across emerging markets however the picture is not homogenous,” notes Raoul Ascari, chief operating officer at Sace in Rome. “Some countries are still exposed to market risks – for example the unwinding of carry trades – others continue to have large current deficits whose cost of funding will be rising sharply.”
Right now innovative financing instruments are suffering most, he notes. Financial vehicles that supported big export credit sales by borrowing on the commercial paper market are, for example, frozen. Meanwhile Sace’s staple business – large project financing and structured financed transactions – continues unabated.
“Those insurers that dabbled in CLO/CDO protections could be sitting on ticking time bombs. And those with exposure to marginal ‘developed world’s creditors in markets that rely on housing growth, construction, etc, are probably at risk,” says Steeds. “Bread-and-butter” transactions like short-term trade LCs and oil sales should still be acceptable, he adds.
Catlin is also wary of dredging contracts and power purchase agreement, “but these are types of deals we have avoided for some time,” Steeds adds. Similarly, while the Kazakh banking sector has been hit by liquidity fears it is unclear whether the credit crunch causes these or whether they were in the offing anyway. “The credit crunch has certainly exposed certain perceived imbalances.”
On the upside, countries with oil and gas reserves will continue to present fundamentally sound risks for insurers to underwrite “as we are left looking at the ‘won’t pay’s (selective default), not the ‘can’t pay’s scenario.” Kazakh, Nigerian, Russian and Angolan government risk is still sound and oil needs to crash below US$30 per barrel before it causes Catlin concern, he adds.
Russia and Nigeria are not immune though, as countries already suffering capacity constraints could weather the biggest impact, Robson argues. “Russia, Nigeria and to a lesser extent China are probably all good examples of where capacity is relatively tight and has probably tightened in recent months and weeks.”
Sectors that are immune to supply-chain disruption could also suffer, Cooper says. “Often raw materials or components are imported into a country, only to be re-exported as a finished product. Excessive inflation, a slowdown in the infrastructure necessary for trade, and threats to trade or country markets highlights risks to trading and investing,” he says.
Automotives in Thailand, textiles in Cambodia and Vietnam, and electronics in the Philippines – all sectors where ‘just in time’s and ‘fully flexible supply’s are demanded – could therefore be vulnerable, he says.
TFC is also sweeping up an increasing number of transactions in Asian countries that are over-reliant on the US market and where lenders are concerned about aggregated country exposure, he notes.
Otherwise, Asia has been very little impacted by the sub-prime crisis, although inflation is fuelling a rise in political risk.
“In Asia, inflation is not just a hypothetical concept – social instability is a direct result of increased daily living costs and hence the political risks of a country,” says Cooper. “Burma’s recent riots, although suppressed by the military dictatorship, were initially caused by riots over food and fuel prices. China, Indonesia and Malaysia, among others, have seen rioting and other signs of discontent directly related to increased inflation.”
Liquidity restrictions in emerging markets, especially for infrastructure project financings, will likely increase the need for political risk insurance – though the impact may not be seen until later next year, Robson predicts.
“If liquidity is severely restricted you would anticipate that the role of the public sector through ECAs and multilateral development banks will be very important.”
“There is an opportunity for ECAs here because ECA-covered loans are considered to be reliable and their risk analysis is normally more transparent and therefore attractive for lenders and borrowers,” says Schrijver. “Last year was a bit flat for many ECAs. We expect business to grow next year.”
Increasing selectiveness by banks – not only to corporates but to sovereign buyers and across all sectors – has created a vacuum that ECAs can fill. “ECAs can play a stabilising role here as they did in earlier crises and can form a more vital link in the flow of goods and services on one hand and capital on the other hand,” he adds.
However, despite there still being enough liquidity in the market, structuring and closing a deal has become harder both for banks and the ECAs supporting a deal, he notes. ECAs have to stay as alert as their private sector partners and will need to gather better information on banks where ECAs have covered risks, especially in Russia where many ECAs have exposure.
If any financing sector can weather the credit crunch, agree most insurers, it is trade finance.
“Trade finance has a tremendous track record in performing through economic cycles and the levels of ‘loss given default’s are very good compared to many other areas of finance,” says Robson.
“The demand for commodities remains very high and the combination of large volumes and high prices means that trade finance will as ever remain very important.”
That’s not to say it would prove immune to broader economic problems, should current credit problems persist, he notes, “but this said, trade has to keep flowing.”
“Trade finance/insurance has been among the least affected classes by the turmoil,” says Ascari. “While the portfolios of companies like Sace used to be skewed towards the riskiest part of the asset distribution, now it has moved towards the centre as the spreads of other assets have widened so much.”
“Transparent, short-term trade transactions are at the other end of the transaction spectrum from CDOs, so they’re more resilient in this market,” adds Armour. “In the medium-term and political risk markets, longer development times and extensive risk assessments and structuring also contribute to stability and a long-term view of risk. Also, continued optimism about the ‘real economy’s and around commodities and infrastructure means that the deals continue to flow.”
“Trade credit markets, driven by a booming trade and commodity cycle, have yet to feel anything similar to the sub-par credit bubble,” agrees Léonard.
According to Alliant analysis, for lower-quality loan assets – which imply lower default rates in insurance portfolios – trade credit spreads have been tighter than those of credit default swaps and others, providing risk transfer at a better price than the financial markets. This was “unexpected.”
“While the sub-par bubble had to do with inflated real estate prices, the expansionary cycle in trade and commodity finance likely led to lower lending standards, always associated with expansionary credit cycles, and we are waiting to see these risks starting to unwind and playing close attention to emerging market-US-EU credit spreads in determining the likelihood, severity and timing of such unwinding,” he adds.
Trade as debt
Others express more concern about the sector. Trade credit has become the “new debt,” with credit terms extended significantly and some of Atradius’s clients having to wait longer to get paid, says Purrington.
Furthermore “trade finance directly deals with some of the debt vehicles that are at the heart of the [credit crunch] issue,” he adds. “From that standpoint, the financing markets will likely be less liquid, more expensive and more risk averse.”
For the moment though, “it’s business as usual” for trade credit insurers, says Steeds. “For those insureds with good experience, we trust their judgement with regard to risk.”
“We continue to back our normal commodity trading clients and banks,” he adds. However, “we are probably less willing to take unsecured bank-to-bank lending risk, particularly on obligors that would be expected to receive minimal government support in the event of an ‘event’.”
Keeping a clear, calm head is one of the best ways insurers and ECAs can meet their clients’s needs in these confusing times, most say.
“While there is certainly a heightened risk of corporate failures our customers look to us in terms of certainty for continuity of cover from a stable business partner,” says Purrington. “There is no panic or knee-jerk reaction reaction and as a result our clients are largely unaffected despite increasing risks.”
Another way Atradius has been supporting its client base is through a series of roadshows through which it has communicated to brokers its stance on the credit crisis and how it can help them in addressing customer needs, he says.
Innovation is also key. There are ways of approaching how one manages and distributes risk that have significant value and there is product development work that can be done, particularly in terms of products that improve capital relief, says Robson.
“The Basel II environment will place a clear focus on the nature of insurance products from January 1 next year in the UK, and this, combined with credit restrictions generally, will mean that the insurance market has to take steps to deliver new or enhanced products if we are to add real value to the banks.”
“We have made very significant progress in this respect and this is a productive time to be in such a position.”
Back to school
In some ways, the credit crunch has thrown up as many opportunities as obstacles, both for insurers and for the clients and banks they back.
There is still much though that players need to relearn, not least the old lesson of ‘know your customer’, says Purrington.
“Now, more than any other time over the past few years, you should be paying close attention to your receivables and the creditworthiness of your customers,” he says.
Insurers also need to introduce more systematic analysis of risks and pricing, Léonard argues. “The discrepancy we found with financial markets shows that underwriters may be underpricing risk, which though useful for clients in the short term may lead to an increase in defaults and then less capacity.”
Pick your clients carefully and don’t underwrite risk that you cannot either understand and/or price, adds Holley. “If it looks too good to be true, it probably is.” For banks and clients meanwhile, now is a good time to buy insurance – to lock in prices and capacity.
“It is easier to get insured before the claims start coming than after you have claims,” agrees Purrington. “And although premiums will likely rise in coming months, “they may still be less expensive than the loss incurred if one or more of your customers defaults.”
A number of valuable lessons have also already been learned. First, that “surplus capital and liquidity doesn’t push pricing down – it encourages poor lending and underwriting decisions,” says Capon. “From initial risk assessment, to security packages and ultimately documentation there has been significantly lower attention to detail and thoroughness. Particularly among banks but also insurers.”
“An important, and somewhat obvious lesson with the benefit of hindsight, is that funding long-term positions with predominantly short-term funding that is subject to high volatility is not ideal!” adds Robson.
“The propensity for volatility was something that we had perhaps forgotten given the amount of liquidity we have seen in recent years. This said, the overall capital marketplace remains deeper than it has ever been, and this implies that some historic lessons have already been well learned.”
Ultimately, we have learned that “the credit cycle is always with us,” Holley adds. “The names of the products – securitisation, CDOs, SIVs and conduits – may change, but the fundamentals are the same and the cycle behaves the same.”
Not all of us learn from our mistakes though, Purrington argues. “For the financial markets, a return to more prudent analysis of investments is the lesson of the year. Consumers may have learned that lending standards are there for their protection as well as that of the lending institution.”
“However, tightening seems to be more on the end of commercial rather than consumer financing, and central banks are doing what they can to stave off a recession,” he notes. “Therefore we have our doubts that a big lesson has been learned.”
On the upside then, deals are largely still being done, pricing hasn’t become unpalatable, insurers still have appetite and it seems we’ve at least learned a little. On the downside, we don’t really know what we’re in the midst of and some of the most influential players are apparently not even on its case.
“We don’t know how long it will take to recover from this because we can’t be sure we’ve seen the bottom,” notes Purrington.
“It’s a bit early in the process to know what the full fall-out will be and how it will interplay with other emerging risks such as the slowdown in the US economy and rising inflationary and thereby policy pressures in emerging markets and particularly Asia,” notes Capon. “We think this is just the start of a change in the cycle – it may take 18 months, it may take three years to really get to the turn, but it does seem to be coming. We do not foresee a sustainable long-term recovery.”
Talking of recovery suggests we have a need for recovery and that we have suffered an event that is now over, neither of which are apparent, Robson says.
Stock markets have regained their pre-August levels and our economies have not started going backwards. Credit however has become tighter and issues including a high oil price, the credit crunch and rising interest rates could trigger bigger problems than we’ve seen yet. “It’s certainly too early to talk about it being a finished historical subject.”
For the moment then, the waiting game goes on.