Over time the political risk insurance market has offered increasingly comprehensive coverage for bank loans. We invited Jack Barnes, a Senior Consultant at Willis Limited with thirty years’ experience in financial risk insurance and reinsurance broking, and David Neckar, Practice Leader for Willis FINE Political and Trade Credit Risk Business with more than twenty-five years specialist financial risk experience in broking and underwriting, to describe this evolution and the current state of the market.
The Evolution of Bank Loan Coverage
Banks have been using private market political risk insurance (as an alternative or complement to state-backed export credit agency schemes) since the early 1980s. At that time the private insurers had recently started to offer public buyer non-payment under the generic of “contract frustration” directly to exporters and traders. Unfortunately, in the few instances in the early days where banks were the insureds, there were some substantial claims. Insurers turned against “bank insureds” so, for the most part, the banks had to content themselves with an indirect position of assignee to the proceeds of the policy (“Loss Payee”) for many years thereafter.
However, following the breakthrough into longer period covers in the late ‘90s, the insurers began to offer expropriation-based coverages to banks for loans to borrowers in emerging markets under policies that were known as “Lenders Form.” After the Argentina crisis in 2002, banks moved to buying “Comprehensive Non-Payment” cover, which has now become the norm.
The Impact of the Last Argentina Crisis
The difficulties that some banks encountered over claims in Argentina were partly caused by a failure to appreciate that Lenders Form cover required a loss to be clearly caused by the combination of (a) loan default and (b) expropriation of the borrower or—sometimes—(c) inconvertibility. Crucially, loan default caused by economic difficulties, local currency devaluation, and borrower insolvency was normally excluded in these policies. The dividing line over whether pesification was tantamount to expropriation was arguable – and therefore did lead to arguments. It is important to note that many claims were ultimately paid on these policies but, for a while, the banks withdrew some of their business from the market, and a number of Lenders Form policies were cancelled.
The banks that had purchased Comprehensive Nonpayment coverage in Argentina collected their claims without problems: the coverage was simpler since it only required the loss to be caused by the failure of the borrower to pay in accordance with the loan agreement. It was no surprise, then, that the lesson learned by the banks was only to buy Non-payment cover, even though it was more expensive than Lenders Form. The banks’ appetite has continued to grow for Comprehensive Non-payment cover, and they are now the largest regular buyers of political risk insurance.
How Non-payment Premiums Are Determined
Premium levels for Non-payment cover tend to move with bank spreads. Currently, as spreads are reducing, so are premium rates. Insurers typically quote a percentage of the bank’s lending margin, but most insurers have a “floor” price for a risk, which is arrived at independently of the margin, usually as a function of their exposures (e.g. country, obligor, trade sector). In cases where the “floor” price is above the loan margin, banks have to contribute part of their fee.
The Impact of Basel II
Even before the advent of Basel II, banks had been seeking clearer and less conditional policy forms. As mentioned above, the move to Comprehensive Non-payment post-Argentina was an obvious first step. The next stages were to eliminate, as far as possible, unnecessary verbiage, which was a legacy from old forms. Lloyd’s, in particular, has been slow to remove exclusions that other markets had dropped or modified some time ago, but will shortly announce its changes.
Banks that adopt the Advanced Internal Ratings-based approach under Basel II have considerable discretion, it appears, to use conditional credit risk mitigation. However, the issue for the other approaches and in general is not the conditionality itself but whether it relates to actions within the control of the bank. The non-payment product can be made sufficiently clear, and the conditionality sufficiently Insured-specific, to make the policies fit the requirements of Basel II—with only one issue remaining: that of the “nuclear exclusion” (the full title of which is “Institute Radioactive Contamination, Chemical, Biological, Bio-Chemical and Electromagnetic Weapons Exclusion Clause”). Some insurers are willing to remove that exclusion, but, even if it remains in the policies, it appears that many banks are prepared to consider such policies as acceptable. There has been no public comment from regulators or rating agencies.
The Future of Insurance/Bank Relationships
Considerable expansion of both demand and supply is likely. The signs are clear at this point: many banks are starting to treat insurance alongside unfunded risk participation, credit default swaps and syndication as an acceptable credit risk mitigant. Insurance actually has the advantages of bespoke fit, confidentiality and not requiring “mark to market.” Insurers are showing much greater willingness to adapt their policies. As both sides actively seek to develop closer working relationships with each other, the relationships could develop in a similar way to insurer/reinsurer relationships. But that will require banks to open up their risk-taking processes and make longer-term commitments to insurers—to which insurers in their turn will have to commit themselves. Indeed, this development of reinsurance-type protections could lead banks and brokers to develop stronger relationships with the large reinsurance companies. ■