From coffee house to counting houses: David Neckar, Client Director, Financial Solutions at Willis Towers Watson, shares his thoughts on insurers and banks and their growing partnership in credit risk.


When the early pioneers of political risk insurance began to offer cover to companies for their overseas investments and their contract bonds and payments under export contracts, they could hardly have expected that this small, specialist class of business would lead to the creation of a multibillion dollar global market. Political risk insurance has developed to provide cover to banks, going well beyond basic political risks to include complex credit coverages and plays an important role in supporting the capital bases of financial institutions – and thereby underpinning the development of world trade.

A key catalyst in this transformation has been the evolution of bank regulation driven by the standards set by the Basel Committee on Banking Supervision (BCBS).

Much has changed in the coffee house – as well as in the counting houses. This article considers these changes, their catalysts, the current state of the market and the upcoming challenges for all involved parties – including the brokers, whom one might consider to be the fourth catalyst.


Banks’ attitude to insurance

Banks had been sceptical of the value of insurance in the 1970s and 1980s when the Lloyd’s offering focussed mainly on expropriation. They tended to think of insurers as either conservative to the point of being antiquated or as unwilling and untrustworthy counterparties.

However, during the 1990s some banks began to insure “country risk” (principally on the Lenders Form of Expropriation, War and Exchange Transfer cover). Banks accepted a level of coinsurance and insurers began to make more informed analyses of economic as well as political risks – sometimes aided by banks’ supporting information, often with the aid of brokers doing the research.

One of the key drivers of this development was the fact that banks were taking some degree of country risk relief from the insurance policy.

In the early 2000s Argentina’s debit crisis provided the watershed moment for the market: Lenders Form cover did not respond to commercial defaults and in the ensuing period of claims disputes many banks, perhaps unclear as to the coverage they had purchased, were vocal in their condemnation of the insurance market.

It was obvious to all informed players that the market’s future lay in Comprehensive Non-Payment Insurance (CNPI), but banks generally remained sceptical about insurance.


Insurer’s increasing comfort with credit risk

Insurers bruised by the Argentina experience in the early 2000s, pointed out that they were largely underwriters of political risk and that the disputed Lenders form coverage was not “credit” insurance.

Basel II provided the turning point in the mid-2000s: here was a statement that if insurance was constructed to be closer to a guarantee, then it could offer risk capital reduction and even regulatory capital relief.

The basis for the eligibility of insurance rested upon a Quantitative Impact Study FAQ (no 6 of 20 December 2002) where the question, ”If a bank is using a credit risk mitigant, like insurance, that effectively functions like a guarantee is it allowed to treat such mitigants as an ordinary guarantee?” was answered, “Yes, provided that such products meets the operational requirements for guarantees laid down in paragraph 154 to 165 of the Technical Guidance any product may be treated as a guarantee.”

Policy wordings therefore became a key focal point and by the late 2000s insurers reduced the conditionality of the policy form, in compliance with the operational requirements of the Basel II Technical Guidance. The two factors crucial in helping underwriters make this significant step were: banks willingness to provide detailed, often proprietary, credit information plus their willingness to take a material share of the insured risk.

As the business started to grow, insurers began to resource their underwriting teams with credit analysts, creating conditions for informed exchanges between banks and insurers – each now seeing the other as a risk partner. The corrosiveness of the past approach and the mistrust were banished.

This partnership was put to the test in the 2008/09 Global Financial Crisis (GFC). To the relief of all parties the cover emerged vindicated and affirmed. Insurers have paid over US$3bn in claims, promptly and efficiently, to regulated financial entities in the years since 2007 and banks have shown themselves as diligent managers of restructuring and recoveries.


Evolution of bank regulation

The 2006 revision of the original 1998 Basel I Capital Accord, was titled “Revised Framework Comprehensive Version”. It focussed particularly on credit risks and banks’ capital bases. If it was a radical development for the banks, it was a game-changer for the insurers.

Insurance – subject to the regulatory caveats of eligibility, legal validity, and incontrovertibility – became a business enabler, not an unwelcome expense. One bank described it as: “a means of mitigating country risk; an aid to increase market share and syndication positioning – a means of enhancing profitability and delivering regulatory capital benefit.”

In Europe in 2013 the Basel II framework was enshrined in law and given EU-wide regulatory force by the Capital Requirements Directive, CRD IV and its accompanying Capital Requirements Regulations (CRR) which were phased in by January 2019.

However, the GFC in the intervening years had highlighted the shortcomings of Basel II, particularly in respect of funding, liquidity and valuations of market positions. Basel III was born and issued in 2010.

Debate and assessment within the regulatory world did not stop with Basel III and CRD IV/CRR. Regulators were troubled by the complexity of the different bank’s internal models which made it hard to make comparisons in the pursuit of that elusive “level playing field”.

In 2017, Basel IV was born, although the name given on the birth certificate was “Finalising Basel III”. The changes which are now required go well beyond what was foreshadowed in Basel III. The notable feature of the proposed new rules is the severe emasculation of the Advanced Internal Ratings Based (AIRB) approach. Banks’ ability to keep the Risk Weighted Assets (RWAs) at a favourably low level has been crimped by the requirement that the AIRB output is compared to the output using the Standardised Approach (SA) and a floor of 72.5% of the SA number be applied.

The implications for the larger, more sophisticated banks will be penal as the European Banking Authority (EBA) graph indicates.



Upcoming challenges

The challenges facing banks are the familiar ones of managing a limited capital base under greater regulatory pressure, dealing with higher costs of compliance and coping with an increasingly competitive environment. The Basel IV world is not likely to make insurance less valuable, but it may give rise to a need for solutions which go beyond basic individual unfunded risk covers.

Insurers are well placed to respond. The credit insurance area has seen a steady increase in capacity and market participants, but it has not led to a breakdown in market discipline. Underwriters have been encouraged to develop products for more advanced solutions for complex financial risks, where the capital relief derived from insurance can be substantial – and where the insured represents a long term partner.

John Wake, our Global Head of Financial Solutions Structuring, says “Over the past two years, we have seen increasing interest from both banks and insurers in transactions that are outside the mainstream credit and political risk insurance model, including contingent close-out gap risk, derivative counterparty credit, insured loan distribution structures and Capital Relief Trades for loan portfolios.”

For brokers the opportunities are considerable, provided they can marshal knowledgeable resources and present informed analyses to assist the underwriters in making safe, incremental steps into new product areas.


Regulatory thoughts

The next few years will see the implementation of Basel IV in law and regulation. To date, under the Basel rules, credit insurance has not been specifically identified and regulators seem to have been unaware of its importance.

The UK’s PRA published a Consultation Paper in February 2018 but following a barrage of criticism from the industry, the authority issued a subsequent response in March 20194 which has gone some way to redressing the position and acknowledging the role of insurance in providing valid credit risk mitigation (CRM).

Comfort can also be taken from the EBA’s recognition of the effectiveness of credit insurance for CRM.

Looking at the regulatory future, the main event will be the transposition of Basel IV into law and regulation in the EU (and of course the UK). The current challenges for all participants in the credit insurance market are:

  1. To make the value and effectiveness of CNPI known and understood more widely.
  2. To have credit insurance clarified and recognised in the regulations, to ensure that insurance policies are treated differently from unsecured loan exposures, reflecting the superior position of a policyholder as a creditor.