The Prudential Regulation Authority (PRA) has issued the highly anticipated outcome of its consultation last year on the eligibility of guarantees as unfunded credit protection. Audrey Zuck, director at A2Z Risk Services, reports exclusively for GTR on the key takeaways from the response.
Last year’s consultation sparked an unprecedented effort from the insurance industry to explain the merits of non-payment insurance as credit risk mitigation (CRM). It did so in co-ordination with the banking industry, which was concerned that the PRA’s proposals would impair their ability to use this product. Responses were submitted to the PRA in writing and in meetings.
The PRA’s Policy Statement PS 8/19, out last week, has been welcomed as a largely positive outcome to the consultation, particularly its focus on lenders themselves identifying and managing residual risks from their use of unfunded credit risk mitigation instruments, rather than the PRA dictating the terms of the credit protection.
Of particular note are the following:
- The guarantor is still required to pay out without delay to meet the requirement of payment in a “timely manner” upon the default of the underlying obligor. But the PRA decided not to impose a deadline of “days, not weeks or months” after the underlying default, and instead requires that the lender ensure that it has certainty as to when the protection provider is obliged to pay out, rather than be hostage to circumstances beyond its control. As noted in industry responses to the consultation, the interactive claims process, legal protections for insureds, and contractual deadlines with regard to claims processing and settlement have provided bank insureds with the necessary assurances with respect to non-payment insurance.
- PS 8/19 refers to a “new” expectation that lenders identify risks arising from eligible guarantee arrangements, including the risk that they do not fulfil a contractual obligation. This was highlighted in insurance industry data that showed that all non-payment claims made by regulated financial institutions were paid in full and on time – except where the insured had not fulfilled clear contractual obligations within its control. Discussion in PS 8/19 of exclusions standard in insurance policies acknowledged that, provided the bank can make the case that the exclusion is immaterial to the exposure and the risk of obligor default under that exposure, these terms do not necessarily make insurance ineligible for CRM.
- Lenders are also expected to assess whether the credit protection could become less effective, resulting in residual risks that the bank must take into account in its risk substitution approach, even if the CRM eligibility criteria are met. The PRA expressed concern regarding “broad or vague terms or obligations” permitting guarantors to avoid liability, such as the duty of disclosure under insurance law. This is a more than manageable risk for most banks that use non-payment insurance due to highly bespoke, heavily negotiated template wordings that have undergone extensive legal scrutiny; coupled with the presence of centralised teams and carefully controlled operational processes within the bank and further assisted by expert brokers and external legal counsel.
By explicitly acknowledging credit insurance as a credit risk mitigation tool and adapting its guidance as explained here, PS 8/19 provides a welcome validation of the product just in time for the European Banking Authority’s recent consultation on guidelines on credit risk mitigation, dated February 25. The insurance industry, in conjunction with bank industry groups, is gearing up to respond to this consultation. The aim is to ensure that non-payment insurance continues its role as an effective credit risk mitigation able to support bank lending and associated trade and investment in emerging markets not easily covered by other CRM tools.