At the start of the year, the Prudential Regulation Authority published a consultation paper on the eligibility of guarantees as unfunded credit risk mitigation (CRM), which included some significant points for UK-regulated financial institutions as well as other FIs subject to the CRR that make use of unfunded CRM. Audrey Zuck, director at A2Z Risk Services, assimilated the industry’s response to the paper, and reports on the key takeaways.
Users as well as providers care deeply about the viability of insurance as credit risk mitigation (CRM)
The request for responses to consultation paper 6/18 was met with an unprecedented, co-ordinated effort to make the Prudential Regulation Authority (PRA) aware of the potential negative consequences for non-payment insurance, a widely used CRM tool from which regulated financial institutions often draw capital relief.
A veritable alphabet soup of banking and insurance industry organisations provided feedback to the PRA through written submissions and meetings. Significant efforts went into compiling information on the depth of support available from the insurance market for bank lending as well as how the characteristics of insurance mesh well with banks’ needs. Brokers spent hours poring over their systems and claims files to demonstrate the impeccable performance of non-payment insurance in paying valid claims.
Not only did industry associations respond, but individual banks, many of whom use non-payment insurance as a key distribution and risk management tool for which they also receive capital relief, also provided bilateral submissions.
Other industry associations responded too, highlighting the importance of insurance-backed lending and receivable discounting to exports, small businesses and jobs. Without the support of insurance, much of that credit would be more costly and/or less available, if at all.
More education should be provided to regulators on the unique characteristics and benefits of insurance as CRM
Insurers historically have been reluctant to step out of their role as discreet support to bank lending, and therefore the merits of the product are primarily known to practitioners and beneficiaries. This may also be why the Basel regulations do not mention non-payment insurance as CRM. Instead, regulated financial entities rely on explicit acknowledgement from the Basel Committee and the European Banking Authority in FAQs that insurance can function as effective CRM, provided it meets the operational requirements of guarantees.
This lack of knowledge and understanding is a hurdle that must be overcome, as the alarm generated by the PRA consultation showed how important non-payment insurance is to effective risk management by regulated financial entities. Although respondents posed a myriad of technical, practical and logical challenges to the restrictive proposals, here is a recap of some of the points made about the risk transfer benefits of insurance:
A unique risk distribution tool
- Non-payment insurance indemnifies the insured by paying a contractually agreed amount in the event of default. Although largely uniform in principles and substance, it is a flexible product specifically tailored to match the bank’s exposure.
- As an accrual-based tool directly matching the asset covered, there is no need to mark-to-market the insurance coverage and the bank does not need to manage basis risk.
- It provides coverage where other risk mitigation is either not available or not available in the amount or on the terms required (for example, for most emerging market risks, and for names where the credit default swap market is illiquid).
- The risk is transferred from the underlying obligor to a counterparty operating in a robust sector used to managing risk, with a long-term horizon and diverse insurance and investment portfolios well-positioned to absorb risk in a prudent fashion.
- Full disclosure by the insured under insurance law is reinforced by independent underwriting, where the insurer uses its own analysis and insight to evaluate the risk.
The insurance market has depth
- The insurance market has been developing its expertise in underwriting the risks associated with credit exposures for more than 35 years.
- Estimates of insurance coverage of bank exposures range from US$150-300bn for individual transactions (single-situation, or transactional insurance market). Although not broken down by support for banks versus corporates, the International Credit Insurance and Surety Association statistics show €2.2tn was provided by its membership in 2014 alone, mostly on the basis
of coverage of a portfolio of receivables.
- According to FCI, the industry association, the receivables finance industry in 2017 funded €1.7tn of small, medium-size and corporate business turnover across Europe, over 45%, or €778bn, of which was insured.
- There are more than 50 primary insurance carriers providing non-payment insurance, supported by 20 to 30 reinsurers, providing a significant amount of capital and expertise as well as a robust distribution of risk and diversification of counterparties.
- The product proved itself during the global financial crisis, with approximately US$2.5bn in single-situation (transactional) claims paid by insurers, and insurers of credit portfolios have paid €60bn since the global financial crisis. This is dwarfed by the US$144bn in natural catastrophe-related claims paid, according to Swiss Re’s 2018 Sigma publication, showing yet again the resilience of the sector.
The special characteristics of credit insurance improve the bank’s position compared to other guarantees
- Exposure to insurers is uncorrelated to the underlying obligor risk.
- Policyholders enjoy a privileged position compared to that of unsecured lenders, and regulated insurance companies have minimal, if any, preferential debt.
- Insurers are highly regulated, and the bank’s claim as policyholder is supported by insurance law and regulation.
- Prudential management together with Solvency II capital requirements mean insurers’ capital is highly liquid, with the ability to pay claims a key priority.
- Insurers are incentivised to pay claims, not only due to reputational and external rating issues, but, for example, English law permits insurers a reasonable period to investigate and assess claims, taking into account the size and complexity involved; where the insurer breaches this duty the claimant is entitled to extensive remedy, including damages in addition to any sums due and related interest.
Insurers’ business model suits banks’ needs
- Although a swift call on a parental guarantee offered as credit enhancement makes sense, the cure/claims assessment period under insurance used for CRM allows banks to handle normal delays, including access to hard currency and commercial/credit issues that can be resolved. This is akin to the benefits of a standstill arrangement common amongst lending syndicates to allow lead banks to arrange solutions when the obligor is having difficulty meeting its obligations.
- Banks are able to sort out any problems or delays in payment knowing insurers will step up if and when needed by the bank. The insurer, meanwhile, is undergoing its normal process to validate the claim, in order to meet a demand for indemnification if required.
- A recent survey of the top nine brokers of non-payment transactional insurance for regulated financial institutions over the period 2007-17 showed that 97% of claims made were paid on time/in full. The remainder were “compromised” due to operational failures on the part of the insured financial institution – and yet 44% of the amounts claimed were still paid in settlement agreements.
More work needs to be done
As politicians and regulators contemplate additional changes to bank regulation, such as the finalisation of Basel III through implementation of CRR2 in Europe, they need to be made aware of the potential, inadvertent impact on an important risk management tool for banks. A reduction in banks’ ability to use non-payment insurance risks damaging financial stability, increasing costs and reducing lending capacity and global trade flows. That’s not a lesson to learn the hard way.
Significant efforts went into compiling information on the depth of support available from the insurance market for bank lending as well as how the characteristics of insurance mesh well with banks’ needs.
PRA consultation paper in short
In June the Prudential Regulation Authority (PRA) issued consultation paper 6/18, which addresses certain key operational criteria of credit risk mitigation (CRM) as expressed in the Credit Requirements Regulation, the European Union’s implementation of the internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007/08.
The paper sets forth the PRA’s proposed expectations and interpretation of these eligibility criteria:
- The “timeliness of payment” requirement; that the guarantor should pay out “within days, but not weeks or months” of the underlying obligor’s failure to make payment when due.
- The minimum scope of legal opinions on enforceability; with the addition that the legal opinion should also address whether the guarantee met the eligibility criteria.
- The “incontrovertibility” requirement; not only that the wording of the guarantee should be clear and unambiguous, but that there should be no practical scope for the guarantor to avoid its obligation to make payment, by reference to the terms and applicable law of the guarantee as well as potential scenarios where the obligation could be reduced or avoided altogether.
- Where adjustments could be made to reflect limited coverage; being only instances where certain quantifiable exposures, such as interest or default interest, were not included in the guarantee.
Effective use of CRM, including guarantees, allows banks to obtain capital relief, provided the credit risk mitigant meets the operational requirements, including the requirements addressed in the consultation paper. Financial institutions had adapted policy wordings and their operational procedures for non-payment insurance accordingly.
As non-payment insurance had received explicit acceptance as effective CRM from both the Basel Committee on Banking Supervision and the European Banking Authority, the PRA paper generated considerable concern amongst banks, exporters and insurers. Other products used for CRM were also impacted, increasing the level of response, but this article focuses on the issues for the insurance market and its stakeholders.