The credit and financial crisis of 2008 – 2009 exposed some deep fault lines in global financial markets. Unexpectedly for many, those cracks first opened up in highly developed markets rather than emerging markets, which conventional thinking would say are more vulnerable to periods of deep financial and credit market instability. Of course, emerging markets were not immune to the impact of the crisis, but many of them were better positioned to steer through it than they were in earlier years. For those of us who have been around long enough to remember the debt crises of the 1980’s, the Great Recession “feels” different. Instead of talking about defaults by Brazil and Mexico, we ponder the creditworthiness of countries like Iceland and Greece. And the exploding United States deficit has for the first time raised questions in some minds about the long-term sustainability of the US as the leading global economic power. Although the focus of concern about sovereign creditworthiness has shifted to countries once thought to be less risky, we are reminded that the specter of sovereign defaults is still a risk to financial institutions.
Non-honoring: A different product for changing times
For many years, export credit agencies have been providing protection against the risk of non-payment to their domestic creditors of foreign countries. It is only more recently that the private political risk insurance market began offering non-honoring (NH) coverage to address this risk. This has been the result of a growing demand for comprehensive insurance from the banking sector in the wake of the earlier debt crises in emerging markets, as well as greater reluctance by banks to grant themselves the maximum reserving benefits that had previously been afforded by traditional political risk policies that covered defaults caused by certain specified political risk perils. In addition, the implementation of Basel II (the latest set of recommendations issued by the Basel Committee on Banking Supervision providing a regulatory and governance framework for determining how much capital banks should put aside to deal with financial and operational risks) has the potential to significantly increase the benefits to banks of achieving capital relief by purchasing broader NH coverage, to the extent the bank’s management and regulators permit this. Consequently, NH coverage has become an important and growing part of most medium- to long-term political risk insurers’ product offerings, and an increasing larger part of their portfolios.
In short, NH political risk insurance policies cover the failure of a sovereign or quasi-sovereign entity to honor its payment obligations. There are three general situations where an insured may seek coverage specifically against this risk. The first is when an exporter/contractor is selling to, or has signed a contract with, a sovereign or quasi-sovereign buyer to purchase certain goods or services. For this situation, the political risk insurance market can offer a Contract Frustration policy that covers the risks that the sale/contract is frustrated due to specific political risk perils (e.g. political violence) thereby causing the exporter to lose its sunk costs and profit, and the pure payment risk of the sovereign buyer to the extent the supplier has completed its obligations under the contract and the sovereign buyer has acquired a payment obligation to the supplier. Second is when the sovereign (or sub-sovereign) entity has payment obligations under a contract with a domestic entity in which the insured has an ownership interest, and the insured is seeking coverage to protect that investment. In this case the political risk insurance market is most likely to address this non-payment risk not in the form of coverage that would compensate the insured for the amounts that the sovereign defaults, but rather as Arbitration Award Default (AAD) coverage. Under AAD coverage, compensation would cover the failure of the sovereign to pay an arbitration award. Third, and most common, is when a bank is lending directly to a sovereign obligor, or to a quasi-sovereign entity with a Ministry of Finance guaranty. This third type of NH coverage is the focus of this article.
Evaluating sub-sovereign payment risk
For a PRI underwriter, one of the key considerations is whether or not the ultimate obligor whose payment obligations are being insured is the sovereign government (e.g. Ministry of Finance) or a quasi- or sub-sovereign entity such as a state-owned corporation or a state or municipality. This is important because pure sovereign obligations can safely be presumed to carry the full faith and credit of the government. Thus the underwriter’s analysis can focus on the ability and willingness of the sovereign to pay, and there is likely to be more public information available from organizations such as rating agencies to help make this evaluation. In contrast, a quasi- or sub-sovereign obligor may not formally carry the full faith and credit of the sovereign government, which means the creditworthiness of the obligor must be looked at on a stand-alone basis as well as in the context of likely sovereign support or intervention in the event of a default. To some extent, evaluating the ability (as opposed to the willingness) of a sub-sovereign to pay is easier than evaluating the creditworthiness of a pure sovereign because the sub-sovereign that is a corporate entity has its own set of financial statements which can be analyzed objectively.
More difficult to evaluate is the potential impact on the sub-sovereign of changes in the sovereign owner’s regulation of or policies towards the sub-sovereign. Many sub-sovereigns do not operate on purely commercial terms and benefit from subsidies and other economic distortions that make it more difficult to assess the true creditworthiness of the obligor. However, those distortions are also an indicator of the willingness of the government to support the sub-sovereign and in the case of financial distress to provide direct financial assistance to ensure the sub-sovereign’s ongoing viability. But this is a more subjective determination. One indicator of this is whether the sub-sovereign carries the same rating as the sovereign. In the absence of such a rating or other public information about the explicit or implicit support provided by the government to the sub-sovereign, the underwriter must rely on its own analysis.
Evaluating the ability and willingness of sub-sovereign entities such as cities or municipalities to honor their payment obligations is more difficult than doing so for state-owned entities. The finances of a governmental body are more complicated than those of a corporation, and they are impacted by a broader set of fiscal and economic policies that are subject to changes in the political fortunes of the officials empowered to run the governmental body. That is not to say that evaluating the creditworthiness of such obligors is impossible. Indeed, many such obligors have a long record of fiscal responsibility throughout the economic cycles, and many are rated by the rating agencies. Thus there is enough reliable information in the public record to make, in conjunction with the underwriter’s own analysis, a sound judgment. Risk sharing is an important concept in providing NH coverage, and most PRI insurers will require the insurer to retain a certain pro-rata portion of the risk. Typically PRI underwriters will offer a lower indemnity for quasi- and sub-sovereign obligors (e.g. 90%) than for a pure sovereign payment risk (e.g. 95%) for the reasons stated above.
Other key underwriting considerations
A PRI underwriter can also make judgments about the nature of a country’s relationship with the international financial community, both private creditors and bilateral and multilateral organizations upon which the country may be dependent for debt sustainability. A country’s refusal to engage these sources of financial assistance, or its record of resisting or refusing their support, can affect the under-writer’s risk appetite for NH coverage in that country. Also of importance is the underwriter’s assessment of the insured’s experience in lending to sovereign or sub-sovereign borrowers, and the insured’s ability to deal with its sovereign borrowers in an intelligent, transparent and if necessary forceful but prudent way to minimize any potential loss and to maximize recoveries.
Another important factor a PRI underwriter will consider is the use or purpose of the financing that is to be insured. Underwriters prefer that the funds are being used for a dedicated purpose that serves an important domestic need or that will otherwise promote the country’s growth and thereby enhance its ability to repay the debt.
All of the above factors become increasingly important as the tenor of the insured debt increases. Uncertainty grows as the risk horizon gets longer, and the general long-term trajectory of a sovereign’s economic development becomes more significant in the underwriter’s analysis. The period of NH coverage available in the PRI market can vary depending on the underwriter’s general risk appetite, capacity, and existing exposure.
The importance of recoveries
Another important consideration for PRI underwriters is the potential for recoveries. The ability to achieve substantial recoveries on claims paid is a critical element in the long-term profitability of PRI in general, and specifically in the underwriter’s decision to offer NH coverage. The good news regarding sovereign defaults is that they are usually followed by reschedulings which provide the opportunity for the underwriter to recover any claims paid, albeit under terms less favorable than those applied to the original instrument. What cannot be known is whether or to what extent any rescheduling will involve a haircut on principal and/or interest and thereby diminish the underwriter’s net recovery. Forced haircuts or debt forgiveness implies that the insurer’s maximum potential recoveries may be less than what was owed to the insured creditor and what is paid by the insurer. This risk must be taken into account when determining whether or not the underwriter will offer coverage and under what terms and conditions. One clue in helping an underwriter evaluate this risk is whether the obligor is a Highly Indebted Poor Country (HIPC) under the IMF and World Bank program. These countries are more likely to benefit from debt relief in the form of debt-forgiveness. Another factor to consider is the potential for a sovereign buyer to restructure its debt under the auspices of the Paris Club, an informal group of official creditors whose role is to address sovereign payment difficulties by debtor countries. Paris Club reschedulings can result in debt forgiveness and/or very long and concessional repayment terms. This is more of a concern for private PRI underwriters when they are directly reinsuring member creditors of the Paris Club since any Paris Club rescheduling that involves debt forgiveness would directly impact the PRI underwriter’s interest in the insured debt.
The sovereign default by the Dominican Republic in 2005 is a good case study of a well-managed debt crisis and the effectiveness of NH coverage. One PRI underwriter had insured several banks that had made loans to the government to finance specific projects and purchases. The government defaulted on these credits in the face of a short-term liquidity crisis that required interim relief in the form of a debt rescheduling. The government worked with the IMF and World Bank in a cooperative way and successfully restructured a portion of its debt to provide some breathing room while the government sought to address the specific issues that had prompted the default. In the meantime the PRI underwriter paid out approximately $15m in claims to its customers, and by the second half of 2010 will have recovered 100% of the claims it paid.
Sovereign payment risk has existed for a long time but it has taken on a new dimension in the wake of the 2008-2009 global financial and credit crisis. Emerging markets have made significant progress in economic development and debt sustainability while more developed countries have shown they are not immune to debt problems. These developments and the pressures of Basel II have helped to fuel the demand by banks for NH coverage from PRI underwriters. These banks use NH insurance as a tool to manage their cross-border exposures, expand their ability to lend to their best emerging market sovereign customers, and make the most efficient use of their capital. Concern about the actual risk of default is often not the principal motivation for buying NH coverage. That banks can successfully lend to emerging market sovereigns supports the notion that PRI underwriters can underwrite this risk profitably as well. A number of factors affect an underwriter’s willingness and ability to provide NH coverage, the most important of which is the likelihood that in the event of a default there will be significant recoveries. ■
Edward Coppola is Senior Vice President, Zurich Surety, Credit & Political Risk. He has over 26 years of experience in the political risk, trade credit and surety business and has held underwriting and managerial positions at U.S. Ex-Im Bank, OPIC, MIGA, and Zurich Financial Services. We invited him to discuss the challenges of underwriting non-honoring coverage.