Credit Risk Insurance
By James Dugdale
What is credit risk?
Credit risk is the risk that a lender takes on when they provide a loan. Lenders provide loans on the condition that they are paid back, usually with interest, and there is a risk that the borrower fails to make the required payments. This risk is called credit risk, and credit risk insurance is insurance against this risk.
Who can credit risk insurance benefit?
Banks and other lenders
Credit risk insurance can help banks, or other lenders, manage the risk of borrowers defaulting on loans. Reasons a borrower may not be able to pay back a loan include insolvency and bankruptcy. Credit risk insurance is one of the many ways a bank can mitigate risk. Other ways of managing risk include syndicated loans (see our guide on Asset Finance for more details), which spreads the risk of a borrower defaulting on a loan across a number of lenders.
However, credit risk insurance is unique since it is a covert way of managing risk. This means that the borrower is unaware that the bank is taking out credit risk insurance, and will prevent the bank from giving the impression that they are not confident in the borrower’s ability to pay back the loan. Banks may find this advantageous as it can protect a strong bank-client relationship, as well as prevent the market from assuming that a deal is particularly risky.
Banks and other lenders, however, are not the only stakeholders who can benefit from credit risk insurance. Governments can benefit by providing credit risk insurance, as it can give exporters confidence to trade with overseas buyers. This insurance would mitigate the risk of overseas buyers failing to make the required payments. Such insurance can make exporters more willing to invest in a certain sector, and can provide an economic boost to local economies and increase international trade.
By providing credit risk insurance, a government may, for example, encourage an exporter to invest in an iron ore mine, which would provide jobs in the local area and increase the country’s export of iron ore. However, governments will rarely provide credit risk insurance directly. Rather, they usually set up government-mandated export credit agencies (ECAs) which would provide government-backed insurance (amongst other support such as loans, guarantees, and bonds).
A bank must always have access to a certain amount of capital, as required by its financial regulator. This is known as capital requirements. Capital requirements in the UK are currently regulated by the Financial Conduct Authority (FCA) and the EU’s Capital Requirements Regulation (CRR) and are subject to the Capital Requirements Directive (CRD).
The FCA’s General Prudential Sourcebook states that, “The adequacy of a firm’s capital resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise” (Chapter 2, Capital, 2.1.4). As such, the capital requirements of banks are determined on a case by case basis, taking into account variables such as fixed overheads, market risk, and credit risk.
Since credit risk is used to calculate the capital requirement of a bank, there will be a limit to the amount of credit risk they can take on (determined by the capital available to a bank). However, by taking out credit risk insurance, banks can mitigate the risk they take on (as the insurer assumes part or all of the risk), and consequently may be allowed to provide more loans without having to increase capital.
Issues surrounding credit risk insurance policies
Each risk insurance policy will have its own terms and conditions, but some of the key concerns include conditionality and termination.
Conditionality concerns when an insurer is and is not required to provide a pay out for a claim. For example, an insurer may want to include within an insurance policy a clause which excludes having to cover the cost of damages that the insured could have reasonably avoided.
Financial regulators will specify which conditions are allowed. The CRR, for example, requires that insurance policies do not include any conditions that allow the insurer to increase the cost of the policy due to a change in the relevant credit risk. This ensures that the insured is covered by a robust insurance policy.
Additionally, the term length of credit risk insurance policies must adequately cover the duration of time before the loan is repaid and the credit risk consequently no longer exists. A policy could, for example, only terminate once the loan has been fully repaid, however, this creates a degree of uncertainty for the insurer who does not know when exactly the policy will end.
An alternative arrangement could allow insurers to terminate the policy with a previously agreed period of notice. The CRR regulates when such conditions can be implemented as well as how long the period of notice must be. This ensures that risk is actually transferred to the insurer, which is ultimately the primary purpose of credit risk insurance.
What happens if a borrower is unable to repay a lender?
When borrowers fail to meet payment deadlines, the lender will notify the insurer. It may be that the borrower requires more time to make the payment, or that they would like to renegotiate the loan, but this would be subject to negotiations with the lender.
If the lender finds the response of the borrower to be unsatisfactory, they may ask the insurer to intervene. The insurer will usually approach the borrower asking for the payment, and if the borrower still fails to make the payment, the lender may send debt collectors to the borrower (this would be dependent on the agreement between the insurer and the lender).
In instances where the borrower is unable to make payments due to bankruptcy, the insurer can deal with the liquidator on the lender’s behalf. The insurer will raise as much capital as they can through these means, and will then pay the remainder of the debt owed to the lender, or the percentage or sum specified in the lender’s insurance policy.
May 2020 – In the midst of the COVID-19 pandemic, the UK's Economic Secretary to the Treasury, John Glen, announced a government plan to guarantee business transactions which are currently supported by Trade Credit Insurance. This plan comes as a result of the economic strain that the lockdown has put on businesses, many of which are at risk their credit risk insurance premiums being raised, or their policies being terminated altogether.
February 2020 – Utah Metal Works, an American scrap metal recycling company, had previously been self-insured and had amassed $150,000 of unrecoverable debt, which led them to take out credit insurance with Euler Hermes. This reduced costs for Utah Metal Works, since the credit insurance premiums were less costly than the losses accumulated by unrecoverable debt.
June 2018 – The British construction company Carillion collapsed in January 2018, leaving behind £800 million in debt owed to subcontractors. Carillion’s collapse contributed to the record high quarterly pay out amount in the second quarter of 2018, which totalled £92 million. 3,639 claims were made that quarter, many of which will have been from Carillion’s creditors.