In an effort to widen and improve the use of non-payment insurance in trade finance transactions, the International Trade and Forfaiting Association (ITFA) has produced a set of guidelines. The document is seen as a step towards meeting demand for greater clarity on policy wordings, writes Rebecca Spong.
While the use of non-payment insurance in trade finance and trade-related transactions has been a fairly common choice for banks looking to increase their risk capacity and obtain capital relief on their transactions, there are mounting efforts being made to improve the use and effectiveness of the product.
The International Trade & Forfaiting Association (ITFA) is spearheading such efforts and last year put together a set of guidelines covering the use of non-payment insurance. It is seen as a step towards improving policy wordings used in insurance documents to ensure that more banks can capitalise on the benefits of using insurance.
“There was a lack of understanding about the product, and it was also a problem that each insurance policy was different, and each time you wanted to negotiate something there were legal costs involved. This is not cost-effective, mainly with regards to the short-term trade finance business,” says Silja Calac, senior surety underwriter at Swiss Re Corporate Solutions and board member of ITFA, who set up the association’s insurance committee two years ago after observing the growing use of insurance among its members.
The guidelines aim to help banks ensure their non-payment insurance policy complies with EU Capital Requirements Regulation (CRR). Non-payment insurance is as an eligible unfunded credit protection for credit risk mitigation that, under EU regulations, can reduce the risk associated with a bank’s exposures. An insurance policy could reduce the risk weighting of a transaction and therefore reduce the capital allocation against that asset.
“Any bank that uses either a standard or x-internal ratings-based (IRB) approach (where x stands for either foundational or advanced) might benefit from capital relief as long as the local regulator approves credit insurance as a risk mitigant eligible under Basel provisions,” says Cengizhan Kaptan, director and expert product manager at RBI International.
“The idea and method is simple; the risk is replaced by or combined with a higher-quality risk that is the median of insurance companies’ ratings. Thus, with the same notional amount of money, capital requirements decrease remarkably as a BB+ or BBB- is replaced by or combined with for example an AA- risk,” he adds.
While the document is considered for guidance only and is not legal advice, with no ‘standard’ wording provided for individual contracts, it is a sign that the market is seeking greater clarity on how to effectively use insurance products. “Since there is no market standard as to the content of insurance policies, to determine and highlight the crucial and essential parts of the product is useful,” Kaptan says.
The need for insurance guidance has in part emerged from the changing dynamics of the trade finance market. Traditionally, ITFA members were banks involved in forfaiting, originating and selling of transactions in the primary and secondary markets.
“The market has changed,” says Calac at Swiss Re Corporate Solutions. “You don’t sell so often without recourse anymore, you’d rather do unfunded risk mitigation because it is easier, quicker and less costly.”
There was a lack of understanding about the product, and it was also a problem that each insurance policy was different.
Silja Calac, Swiss Re Corporate Solutions
“It was all about risk participation among banks themselves. But the bank market couldn’t cover all of this because all the banks have the same issue – they are all suffering from the burden of risk-weighted assets (RWA) – and if they only pass the RWAs between themselves it is not really a solution. So, the insurance market is really the perfect partner for the banks,” she explains.
A survey conducted by ITFA in late 2015 found that insurance is a popular option for banks looking to obtain capital relief, with close to 80% of responding members saying they were using non-payment insurance.
Yet, some respondents also said that there were too many different types of policy wordings in the market – which could often be a confusing prospect for a bank that might be new to the product. It is also tricky for some banks to know what is the “best” wording, according to Katie Fowler, a broker at Texel Finance and a member of the ITFA insurance committee.
“One thing that came back [from the survey] was there were so many policy wordings in our market, they are all really bespoke, so each bank has its own policy wording,” she says. “Banks wanted some standardisation on policy wordings.”
There have also been incidences where banks have not been able to obtain any capital relief from the use of insurance, due to either the wording used in the policy or the bank’s own internal interpretation of the policy. In other cases, poor and divergent wordings could heighten the risk of not being paid in the event of a claim, says Geoffrey Wynne, partner at the law firm Sullivan & Worcester.
“Policies were very different and often quite unclear as to what risks were being covered. More importantly, the responsibility of the insured was very wide, so the risk of a claim not being paid was potentially high. Disclosure requirements were very wide, as indeed was [the definition of] who had knowledge that might affect a claim,” he says.
Almost 90% of survey respondents said they would like to see a standard policy form along the lines of loan agreement forms already created by the Bankers’ Association for Finance and Trade (BAFT) or the Loan Market Association (LMA).
“It would be ideal to have a standardised policy document for insurance; however, my personal expertise and experience in the field tells me that it will not be possible due to historical and technical reasons, at least in the short and medium-term,” says Kaptan.
“Nonetheless, ITFA might lobby with local regulators either directly or through their members so as to promote the understanding and use of the product.”
After reviewing the feedback, ITFA decided not to push forward with a prescriptive standardised form for the time being. “With the BAFT agreement, the secondary market already makes use of similar risk participation agreements. But for the insurance market this is not yet the case, mainly because you have different underlying mitigation products, for example trade credit and political risk insurance, wholesale and single risk cover. There is such a big range of products for banks – so it is not so easy to just have one clear policy,” says Calac.
Fowler echoes this sentiment, saying: “There are some clients of ours who have been using the policies for over 10 years and it has really developed. They have had numerous rounds of negotiations with underwriters and they have a very sophisticated product. But there are also some banks that have just started using the product, or have never used insurance before. There’s a whole mixture among members,” she adds.
Policy wording pitfalls
While some policy wordings may be deemed highly sophisticated, there have been policies that haven’t lived up to the expectations of the insured. Sometimes wordings may not be tailored sufficiently to the needs of a trade finance transaction, says Fowler.
“There are perhaps some wordings out there that may be more tailored for a trader. They use non-payment policies like banks do, but they don’t have requirements that banks need to obtain capital relief. There are certain things within a policy wording that you would need under CRR: timely payment, direct control, some very specific requirements. If your broker is not specialised, they may provide you with trader wording and if it wasn’t bank-compliant wording, then that could be an issue,” she explains, adding that most brokers do try to understand the bank’s business and what it requires.
There may be other incidents where banks haven’t fully understood the product they’ve bought into, says Simon Bessant, director at Texel Finance.
“There are banks that have a history of buying purely political risk insurance as a mitigant for country exposure, which they thought would comply with their credit committee’s requirements to de-risk the country’s exposure. And at some stage when the claims come about, they maybe found the product wasn’t completely suited to the underlying loans they had covered. I think there has been a history of poor understanding as to how to use the insurance policy, and using it to tick a box, rather than improve the capital usage in their portfolios,” he says.
There has been a history of poor understanding [among banks] as to how to use the insurance policy, and using it to tick a box, rather than improve the capital usage in their portfolios.
Simon Bessant, Texel Finance
The guidelines were published in order to coincide with the new Insurance Act, which came into effect in August 2016. The act applies to all contracts of insurance and reinsurance subject to UK law, underwritten on or after August 12 last year.
The ITFA guidelines provide some steer on how the act could affect policy wordings, particularly around the insured’s pre-contractual duty of “fair presentation”, which covers what kind of information the insured has to provide. “It is much friendlier to the policy holder than the previous insurance act,” says Calac.
“These are still early days,” says Wynne, commenting on how the act will affect policies. “But the intention is that the policy wording should be clearer so that key provisions are found in one place and there is no repetition. The liability on both sides should be set out clearly. The insurer benefits from the insured having to make disclosures at the outset.”
To date, feedback on the guidelines has been generally positive, says Calac, who adds that she sees banks getting better acceptance internally for the use of insurance as a risk mitigant.
“They can go to credit committees and their internal departments that set the calculations of their RWAs, and they will more easily accept the use of insurance to get capital relief,” she says.
Alongside the guidelines, ITFA is also running seminars on insurance and has started issuing committee opinions, answering specific queries raised by members.
In an effort to meet demand for more standardisation in policy wording, Fowler says the next step may be to come up with some boiler plate clauses. “There are some very standardised clauses in policy wording which are uncontroversial when negotiating with the underwriters. So, I think perhaps that is the next step to come up with some of these clauses. There are calls for this standardised policy, but I don’t think it will happen anytime soon.”