The use of credit insurance in trade finance

When the British Commercial Insurance Company (a firm established in 1820 to offer fire and life insurance) offered the first trade credit insurance at the end of the nineteenth century, the developed world was going through the midst of the second industrial revolution. Economies were booming and many companies were expanding into new markets.

Such growth naturally brought about uncertainties that manufacturers were thus far relatively unfamiliar with: unknown counterparties in unfamiliar countries. This created a shift in attention towards the need to include credit and political risk when approaching risks and areas to insure. However, it was between the first and second world war that the use of credit insurance really took-off. Since then it has been a well-used tool for risk mitigation with savvy exporters in developed countries.

For many years trade credit insurance was predominantly being offered to corporate clients. In the mid-nineties when growth in Asian economies started to develop critical economic mass, trade credit insurers started paying more attention to Asia Pacific (APAC) as a region, and started to establish a local presence.

In APAC, for various reasons such as lower financial transparency compared to Europe and the USA, more reliance on free cash flows, and varied seller-buyer relationship, the penetration of trade credit insurance with corporate clients was relatively slow to pick up. Instead much of the growth in premium revenues was achieved via factoring companies and trade finance banks.

The growth in the use of trade credit insurance amongst factoring companies can be explained by the following factors:

• Strict Know Your Customer (KYC) requirements in financial institutions

This is especially the case when it relates to trade finance and/or developed markets, where information is largely perceived by the major trade credit insurers to be less readily available and more susceptible to fraud risk, and terrorism funding. As such, on-boarding large numbers of buyers in order to purchase a portfolio of receivables is often a challenge. Trade credit insurance may provide the necessary credit limit relief on these buyers and could help avoid having to on-board them from a credit perspective.

• Factoring as defined by Basel III

Furthermore, if a bank is required to treat factoring without recourse or with limited recourse under the standardised approach under Basel III, banks must base the Risk Weighted Assets (RWA) calculation for the capital adequacy test on external ratings. When backed by insurance, the banks may be able to use the Internal Rating-Based (IRB) approach basing the RWA calculations on the banks internal rating of the credit insurer and then apply a Probability of Default (PD) substitution. In turn, this has a significant beneficial effect on the Return on RWA (RoRWA) calculations of the underlying deal.

• Protection assurance

Even if the bank doesn’t take capital relief, it typically strengthens their protection against credit default risk of the buyer via trade credit insurance.

During 2010-2011 members of the Basel Committee on Banking Supervision (BCBS) agreed on the Basel III Accord to strengthen bank capital requirements. This changed the landscape of trade finance again, as it required banks to hold more capital.

The Accord's main aim was to increase bank liquidity and decrease bank leverage. The amount of capital required to be held under the Basel III Accord varies based on the valuation of the bank’s assets and liabilities. Thus, the resulting RWA position determines how much capital needs to be held. Trade finance banks and factoring companies were heavily impacted because of the nature of their assets.

For banks which have to comply with European Union (EU) regulations, these capital requirements became more tangible on 17 July 2013, after the Capital Requirements Directive IV (CRD IV) came into effect. CRD IV transposes into EU law the latest global standards on bank capital adequacy (commonly known as Basel III).

The CRD IV framework offers the possibility for mitigation of the banks RWA position via PD substitution (as set out in articles 194 & 201-203). When a credit risk mitigant (either a guarantee or credit derivative) meets certain strict criteria set out in CRD IV (as set out mainly in article 213 & 215) it can base its RWA calculations on the PD of the protection provider. These rules aim to ensure legal enforceability and effectiveness of the policy in all relevant jurisdictions. In order to be deemed effective, the policy must amongst others:

 

• Be direct (issued in favour of the bank);
• Be clearly defined and incontrovertible;
• Not allow unilateral cancellation of the credit protection (unless forward looking; retrospective cancellation of cover isn’t allowed as it may leave the bank having taken capital relief on assets post which cover on those assets is cancelled)
• Not to allow increasing effective cost of protection due to deteriorating credit quality of the protected exposure (as such an increase of premium at policy renewal is generally acceptable but a malus clause is usually not)
• Provide an insurer with the obligation to make a timely claims payment under the insurance policy
• Not allow the insurers to shorten the term of the insurance policy (if a policy is terminated, any assets cover until such time under the policy should remain covered)
• Not oblige the primary obligor to be pursued (there should be no obligation to first instigate proceedings against the underlying obligor before making a claim)
• Be clear in the scope of protection; the insurer needs to be clear in the exact share of the risk they are covering
• Proper and formal written documentation to be in place

 

The CRD IV directive has paved the way for banks to use trade credit insurance as a unfunded credit protection, thus allowing them to improve their RWA position, and realise more revenue and return with the same capital footprint. The specific use of credit insurance as a unfunded credit protection in trade finance has split the market. Some banks with traditionally high RWA footprints have picked up the use of insurance fairly swiftly. Other banks, depending on their product offering, regional footprint and capital position, have thus far made limited use of the tool.

Regulators have played a role in this development especially in countries where the use of trade credit insurance for capital relief on bank assets is not allowed, whereas in other countries such as India, credit insurance companies are barred from issuing policies to banks.

One general trend clearly stands out though; with Basel IV in the making and many local regulators aligning with regulators such as the Prudential Regulation Authority (PRA) in the UK, the capital requirements for banks will only become stricter and as such banks will have to develop new ways to manage their capital efficiently. In light of this trend there are increasing levels of active discussions between banks and credit insurers, reinsurers, other banks and development organisations on the transfer of risk on a funded or unfunded basis.

There are largely three reasons for banks distributing assets on their book; credit relief, capital relief and liquidity. Trade credit insurance as a distribution channel is only used for credit and capital relief; liquidity benefits are generally achieved via funded risk participation, or true sale of assets.

As mentioned, taking capital relief is not always an option for a bank. It depends on the regulatory and accounting (IFRS/US GAAP) framework within which they operate and the interpretation of such by the internal compliance department. Historically, we see banks in the USA and Australia not taking capital relief against credit insurance but even in other countries, views on whether a policy warrants capital relief, vary.

Some banks take capital relief against credit insurance backed factoring and invoice discounting deals backed by either an insurance policy held by the (corporate) client – whereby the bank is added as co-insured – or backed by an insurance policy held directly by the bank. Other banks strictly work on their own, known as bank held wording. In defining their policy on how to treat credit insurance as a credit risk mitigant, the banks will have to strike a balance between the (at times onerous) efforts of working with client held credit insurance policies, and the potential loss of business opportunities from only accepting their own bank held wording.

The red line of any wording discussion for a bank will in the end be in how much control they can exert on those situations in which a credit insurance policy potentially doesn’t pay out. This highlights the nature of an insurance policy vis-à-vis risk participation, true sale or syndication; an insurance policy is a contract to cover a specific default event under specific conditions. That means that only specific events (usually insolvency, protracted default and political risk) are covered when certain conditions are met (such as the right premium being paid in time, overdues and adverse situations having been reported in time, instructions from insurers followed up to recover the debt etc.), whereas other distribution channels are less conditional.

By having in place a solid process of policy maintenance, a strong relationship and facility documentation with the client, and a policy wording that allows for any breaches of policy conditions to be flagged by the insurer and remedied by the insured/bank where possible, these conditionalities can be largely mitigated.  Thus, an insurance policy could be regarded by the bank a valid unfunded credit protection under Capital Requirements Regulation (CRR).

It isn’t just regulatory changes either. The technical landscape continues to evolve as well. We experience more and more financial institutions looking at credit insurance as a tool to stimulate origination and funding in the market, reducing the funding gap, especially in emerging and SME markets. The potential is vast. Being able to overcome issues such as fraud risk, economies of scale and default risk, the market for trade finance could be significantly developed, which in turn will stimulate GDP growth and trade flows.

Is trade credit insurance the only answer?

Trade credit insurance is not the only tool to mitigate credit risk. Some banks do not take credit relief at all and generally on-board all obligors, even in a large factoring or invoice discounting portfolio. Other banks have strong syndication capabilities and work together with other banks. Yet others work on the basis of risk participation agreements or securitisation programmes.

Two recent trends bode well for future growth:

 

• Recent technological developments such as blockchain-based platforms and smart contracts allow banks to overcome some of the operational risks and conflicts of interest that they typically face between investors when combining different distribution channels in one deal. For example, an Application Program Interface (API) can help check the eligibility of invoices (in terms of credit limit and e.g. overdue status) and provide a predefined allocation of eligible and insurance wrapped invoices to multiple banks in parallel, without risking the funding of invoices which are not covered by credit insurance, and without the usual reconciliation issues you may have at default when using multiple banks.

 

Though the technology may not be ready for broad application, blockchain technology could in the future help mitigate fraud risk and the risk of sanctions breaches or terrorist funding, by identifying and tracking funds, sources of funds and the movement of underlying goods. If banks were able to identify the source and destination of every dollar, verify each trade document or invoice against an actual movement of goods, and identify exactly which persons were behind which legal entities, fraud, sanctions breaches and terrorist funding in trade finance may one day be a thing of the past.

 

• As per the experience of the author of this article, more and more non-traditional investors, such as pension funds, multi-liner insurers and hedge funds, seem to be looking to buy their way into trade finance assets as the correlation with their own portfolio is generally low, returns are solid and default rates are very low compared to other asset classes. While these investors lack the underwriting and servicing skills to assess and manage such trade finance portfolios themselves, they increasingly rely on specialised outfits or even the banks themselves to provide such tasks for them.

The entry to the trade finance market for these investors is nowadays largely being facilitated by technological developments as per above, and by the rise of service providers who specifically target these type of investors. We’re increasingly seeing more companies - who provide a combination of brokering, underwriting, servicing and structuring services - enter the trade finance market. They help these non-traditional investors get in contact with the banks who originate the trade finance assets, or even with the corporates who raise the invoices. They may help underwrite portfolios of assets and sometimes even provide part of the funding themselves as risk bearing capital. Some offer the possibility to set up and even manage Special Purpose Vehicles (SPVs).Trade finance banks should encourage the arrival of these new technologies and sources of funding. It is clear that banks cannot bridge the funding gap in trade finance alone. Factors such as risk concentration, capital requirements and liquidity provide limits to the appetite of banks in specific industries and geographies. New sources of funding can complement traditional sources of trade finance and their entry to the market will stimulate growth in peripheral services by banks and specialised service providers.

Supported by new technologies and new sources of liquidity trade finance banks would be able to support the economic development of previously underserviced developing countries as well as new industries. This will in turn help reduce global poverty while strengthening political stability. It may even help the developed world, especially Europe, find a new place in the global economy amid shifting forces between the United States of America and China. These goals may sound like ambitious day dreams but perhaps it is time for banks to carve out a nobler role on the world stage than just providers of shareholder returns.

The main challenge to making these trends really count, for both trade finance banks, non-traditional investors and credit insurers, is the same one we faced in the eighties - will the standard be Betamax or Video Home System (VHS)? In other words, standards will be required on regulatory, technical and contractual frameworks that allow banks, insurers and other investors to pool together and provide the kind of support that global trade needs in order to shift back into a higher gear. Despite all the glossy conferences on block-chain and global finance, this will mainly involve the rolling up of sleeves and negotiating such standards in many long sessions.