After years of contentment with the wordings that have been developed in the commercial political risk insurance market since its start 40 years ago, one has recently noticed a shift from insurers’ traditional protection towards contracts which are more favorable to insureds. It has been a soft market for some time with underwriters chasing business which has either not felt threatened by world events or has found alternative balance sheet protection in the capital markets. This competition produces concessions: not just on rates, but on wordings. Although the environment has changed, there remain factors which are likely to keep the wordings developing to the insureds’ advantage.
Originally, commercial PRI underwriters saw themselves as a market of last resort: insuring risks which others wouldn’t take. Faced with projects which were particularly in the knowledge, experience and control of their insureds, they felt more vulnerable than underwriters insuring other risks. This fear was exacerbated by less certainty of ‘repeat’ business in this class. To minimize the risk of being selected against, PRI underwriters developed clauses that were more favorable to them than in other insurance sectors. PRI wordings came to contain terms which had been specially-tailored, and perhaps as a result of a lack of competition from overseas markets and within the London Market itself, the scope for amending these terms in favor of prospective insureds was limited.
The starkest examples of this (but ironically under English law the most ineffectual) were the provisions dealing with ‘Onus of Proof’. The normal position with insurance contracts subject to English Law is that the insured must establish a loss caused by an insured peril, operating on the insured interest during the policy’s currency. If then the claim is disputed, the burden passes to the insurers to establish that an exclusion applies or a condition has been breached. PRI wordings invariably contained a clause purporting to change this: an insured had to prove not only that the loss was recoverable under the policy, but also that “no Warranty or Condition” had been breached and that “no exclusion applies.”
Under English law there are principles of insurance which supported insurers’ defensive attitude. For instance, insurers have protection at the placing of the policy under the principle of “utmost good faith.” Before the contract is concluded a prospective insured must truthfully disclose to the insurers, all “material circumstances”: those matters that an underwriter would have wanted to have in mind in deciding whether to insure a risk, for what price and on what terms. If this duty is not honored, and if the insurers can show they were induced to write the policy because of the non-disclosure or misrepresentation, they are entitled, in effect, to treat the policy as if it never was, return premium and refuse to pay the claim. They “avoid” the policy. Nor does there have to be a causal connection between the undisclosed or misrepresented circumstances and the loss giving rise to the claim.
Then English law has “warranties”: terms of the policy which are, broadly speaking, conditions precedent to the insurer’s liability—typically, a term in which the insured promises either that a state of affairs existed prior to the inception of the insurance or that it will continue to exist during the policy’s currency. If that term is breached then the policy is “repudiated” and insurers’ liability ends. Again there does not have to be a connection between the breach and any subsequent claim.
Not content with relying on these principles, PRI underwriters devised even more favorable provisions in their wordings with regard to disclosure. We had the “basis clause” when the insured warranted the truth of the information supplied, however insignificant to the placement, and the “No Prior Knowledge” clause, embodying subtle and important differences from the principle of good faith and increasing the insured’s duties and the insurers’ rights in the event of the former’s shortcomings.
When the policy was in place, there could also be variations from the normal approach. The usual link between a cause of loss and a right to indemnity, ‘proximate’ or direct cause, might be shifted so that the loss must be caused “solely and directly” by an insured event. Conversely, the criteria for exclusions were sometimes widened so that insurers were exempted from paying where the loss was “directly or indirectly caused by” an event.
These principles: utmost good faith, warranties and the insurer-orientated clauses may shortly be made more difficult to impose on insureds by statute. We have our Law Commissions looking at insurance law. It is likely there will be legislation, and it will extend some principles of consumer protection to what the Commissioners call “business insurance,” including PRI.
In the meantime, things are changing anyway. The market is more mature and the products have expanded. “Confiscation Expropriation and Nationalisation” cover— “CEN” may now be supplemented with refinements such as “deprivation,” “selective discrimination,” “forced abandonment” etc., and there has been a move towards merging more attritional contract coverage, with this long-established cover becoming known as “Full PRI” (or confusingly just “PRI”), or specifically “Investment,” “Equity” or “Loan” insurance. It is now common to find policies providing additional coverage for breach of contract and failure to honor arbitration awards. Other coverages may be added – War and Political Violence/Terrorism. Currency Inconvertibility insurance is available to compensate investors for their inability to convert local currency into hard currency and transfer remittances outside of the host country.
What was described as “Contract Frustration” or CF: cover provided to ensure the performance or payment obligations of public buyers or to protect against the impact of government action on private buyers, has changed too. Changes in the private market have allowed Lloyd’s to insure pure “credit” risks, and now you may find the CF protection extends to commercial “can’t pay/won’t pay” situations. Known as “Comprehensive Non-Payment Insurance” or, more generally, Trade Credit Insurance – TCI, this insurance will cover short and medium term trade and its finance. It can also cover the income stream from projects.
There have been other opportunities that have had their effect. There is Basel II: an “accord” intended to be adopted as law which revises the standards for measuring the adequacy of financial institutions’ capital with a system making banks’ assessments of their loans and investments more sensitive to credit and market related risks, and taking account of operational risk for the first time. When a bank assesses the credit risk in a deal, it can take into account techniques which banks have traditionally used to mitigate that risk: collateralization of loans; third party guarantees; credit derivatives—“credit risk mitigation” or CRM. There is nothing in Basel II about insurance as a CRM instrument, and technically, under English law, an insurance is not a guarantee. Basel II is, however, not a legal document, and commercially a policy can be seen as a form of guarantee. It is the credit risk aspect of Basel II which the London Market sees as an opportunity to sell new products.
If a TCI policy is to equate to a guarantee for a bank in calculating capital requirements, Basel II requires it be “direct, explicit, irrevocable and unconditional.” TCI can meet the first three criteria. It is the “unconditional” where the problem lies. The CRM instrument must contain no obligation outside the control of the bank that could prevent the guarantor from paying in a timely manner if the original counterparty fails to pay.
Traditionally, the TCI policy a bank took out to protect its transactions would contain many general terms and conditions, and if subject to English law it would incorporate the terms and conditions that are peculiar to insurance contracts in general and to PRI and TCI in particular. Foremost would be the concepts of “utmost good faith” and “warranties,” “No Prior Knowledge” clauses and reverse burden of proof provisions. Such a policy therefore created “conditionality”—in contrast with the common perception of a “guarantee” (a couple of pages containing a promise to pay if someone else doesn’t.)
Conscious of this problem, the London Market is striving to produce policies which meet the requirements of Basel II. Such wordings spell out clearly what is insured, premium terms and that the policies cannot be amended, terminated or cancelled except for non-payment of premium. Usually the “No Prior Knowledge” clause is gone. There are other clauses dealing with disclosure—sometimes the duty of utmost good faith is explicitly spelt out. Another approach is to make the duties of disclosure a “warranty.” Sometimes claims resulting from failure to meet the standard of utmost good faith are dealt with by way of exclusion. One also sees attempts to delineate the information provided to the insurers and to confirm its completeness. The bank’s department charged with providing the placing information may be identified to the exclusion of others.
Under policies intended to be Basel II compliant, most of the usual warranties remain. They are within “the direct control” of the bank and permissible. Clauses, however, seeking to reverse the burden of proof have gone, and sometimes the normal insurance rules are expressly set out: the insured has to establish that the loss falls within the policy and its amount, leaving the insurers to establish that a term has been breached or an exclusion applies.
Basel II talks of payments under guarantees being “timely,” and the new wordings seek to make the situation clear. What does the insured do to get a claim paid? What has to be provided as support? How far can the insurer ask for further information? What is the waiting period before the claim gets paid? How quickly does the insurer have to decide to pay a claim? These are dealt with.
The greatest problem in making a policy qualify as Basel II CRM lies with the exclusions. Customarily a TCI policy excluded losses caused by “material default” of the insured – so within the direct control of the bank, but there were exclusions for loss caused by insolvency or financial default, currency fluctuations or devaluations, war involving the five permanent members of the UN Security Council and various forms of the “Radioactive Contamination Exclusion Clause.” All these excluded factors are outside a bank’s control, and so fall foul of the Basel II requirements for guarantees. Company insurers could drop the exclusions, but Lloyd’s Underwriters were required by regulation to insert them. This was a problem which could have prevented the use of TCI policies as effective credit risk mitigation. Lloyd’s has, however, changed its rules. A Market Bulletin issued last year “to address the issues raised by the implementation of the Basel II” provided that CF and trade credit insurances are no longer required to include war, insolvency or financial default or currency fluctuation exclusions. With this, the major obstacle preventing financial institutions using TCI as a credit risk mitigant has been overcome.
Some things have emerged from the Market’s approach to the opportunities offered by Basel II. Wordings are clearer, shorter and more up-to-date. Uncertainties have been removed and exclusions limited. If there is a claim, the position is clearer sooner. These changes could well affect the converged PRI policies and other credit insurance policies even though compliance with Basel II may not be the intention. A bank insuring its foreign direct investment may wonder why brokers cannot secure similar wording to its trade credit cover. One may even see the new environment extending to the classic CEN perils. Perhaps a definition for “expropriation” allied to state default under bilateral investment treaties: something which caters for “regulatory takings”? Maybe we will get a form of prospective arbitration award default coverage for BITs tailored to respond more quickly and more cheaply than the international arbitration process: the sort of thing that would have made the Argentine claims in 2001-2002 so much easier for both insurers and insureds. ■
Tony George is a partner at Ince & Co., where he currently devotes himself to political and trade credit insurance advice and litigation. We invited him to discuss developments in PRI and TCI policy wordings in the London market.