In last week’s post, I mentioned political risk insurance doesn’t cover insolvency and protracted payment default; for that you need comprehensive nonpayment policies. This week, I’m going to explain what they do.
Very simply, comprehensive nonpayment policies cover an insured against an insolvency or protracted default by a customer, counterparty or borrower. It does not matter if the reason for the default was straightforward insolvency or political interference, it should cover the insured regardless.
Please note it is not a guarantee, it is an insurance policy with conditions and exclusions.
The areas within financial institutions that have the greatest need for the product are those operating in the following areas:
- Project and export finance
- Commodity finance
- Trade finance
- Securitisations/capital markets
- Asset-based finance
- ….essentially any area where the Financial Institution’s balance sheet is exposed to a credit risk.
Why is it important to banks and other financial institutions?
- Capital allocation benefits (Basel II / III)
- Country and counterparty risk transfer
- Constraints on country / counterparty limits
- Protection of loan security
- Maximise margin / fee income
- Flexibility compared to ECAs/multilaterals
- Available for small tickets
- More cost-effective than other distribution channels including credit default swap market
- Distribution to non-competing entities (protects bank’s intellectual property)
What Risks Are Covered?
The cover is quite straightforward. If an insured enters into a contract, the policy is designed to cover the insured against any loss as a result of the other party failing to meet their contractual obligations. For banks, the policy covers a failure of a borrower to make the repayment under the loan agreement (whether protracted default or insolvency).
There are a variety of covers:
- Comprehensive non payment (private obligors) (also referred to as trade credit insurance)
- Contract Frustration (nonpayment by public obligors)
- Non-honouring of letters of credit/guarantees (or other standard trade instruments)
- Non-honouring of sovereign obligations/guarantees (includes government-owned and quasi-sovereign entities) i.e. where an otherwise private company transaction receives an overt separate guarantee from the government, often in the form of a Ministry Finance Guarantee
- Non-performance by counterparty under a contract (also known as non-delivery), which covers the performance risk on a counterparty. The cover is similar in that the underlying contract will require repayment of any prepayment.
All of the above covers are collectively known as Comprehensive Non Payment Insurance. Which one of them is applicable depends on the structure of the underlying transaction/loan agreement, and whether the obligor is a sovereign entity or private company.
What Risks Are Not Covered?
As comprehensive nonpayment insurance is an applicable credit risk mitigant under Basel II/III, the wordings now have to meet Basel requirements, which translates to reduced conditionality. In short, any exclusions under a Basel II/III compliant policy will be within the control of the bank–i.e. excluding any loss arising as a result of fraud by the insured, insolvency of the insured, material breach by the insured in the underlying contract (all within the control of the bank).
Non-bank financial institutions will find that their policy exclusions are a little broader as Basel II/III does not apply, however the wordings are still much tighter than previously experienced as a result of the Basel compliant process for the banks.
Commercial/ private market insurers:
- Company markets
- Export credit agencies – for example SACE, the Italian export credit agency; COFACE the French export credit agency
- Multilaterals – Multilateral Investment Guarantee Agency (MIGA), part of the World Bank; African Trade Insurance (ATI).
Factors to consider when choosing between Private markets and export credit agencies / multilaterals:
- Speed of response
- Documentation risk
- Local content rules
- Down-payment / Commercial loan
- Double trigger
Similar to political risk insurance, the limits need to reflect the full value of the loan or contract. The difference being that, under comprehensive nonpayment policies, the insurers will expect the insured to always retain a certain proportion of the transaction uninsured (normally 10%) to ensure the insured still has an interest even after the payment of a claim (to keep the insured and insurer’s interests aligned).
Comprehensive nonpayment is one of the most binary of insurance products available; however there are always a few things to be aware of:
- General corporate-purpose loans – The majority of the market will not cover general corporate-purpose loans – comprehensive nonpayment needs to have a defined purpose. Lloyd’s insurers will require all loan facilities to have a ‘trade’ related aspect to it (the definition is quite broad).
- Nuclear exclusion – Many insurers will require this to be included in the policy, which can be seen to mean the policy is not Basel-Compliant
- Disclosure of all material facts and pertinent information is crucial.
- Make sure insurers are informed of any potential default and are kept up to date at all times.
Comprehensive nonpayment insurance used to be almost exclusively purchased by UK, European and US companies. We are now seeing that companies who previously were the party of risk (i.e. the obligor) are now approaching us for cover.
Emerging market banks are starting to get their internal credit models signed off by the respective regulators and become advanced internal ratings based banks (AIRB) and therefore able to use comprehensive nonpayment insurance for regulatory capital relief.