Effective Use of Insurance Policies for Capital Mitigation

Insurance/ Reinsurance November 2013

EFFECTIVE USE OF INSURANCE POLICIES FOR CAPITAL MITIGATION

For the purpose of Basel II and III (and the First Use of insurances can greatly increase rates of Pillar), banks are required to calculate their return on capital as well as replacing elements minimum capital requirements for credit risk, of regulatory capital. Indications from certain operational risk and market risk. financial institutions are that insurance products can (currently) replace upwards of 25% of their In relation to operational risk, this has been regulatory capital (and perhaps more in certain addressed both by the insurance market and circumstances). regulators over a number of years, and capital haircuts (of up to 20%) are available to banks Credit risk insurance is increasingly being used in which adopt the Advanced Measurement more complex transactions (although the credit Approach. Currently, the evidence is that upwards risk trigger for policy coverage should be defined of 12-15% of a bank’s regulatory capital is carefully) e.g. covering credit risks on derivative deployed in addressing operational risk. transactions, including margin shortfalls and “slippage”. In addition to operational risk, insurance products have been incorporated in banking institutions’ Below we discuss two principal forms of cover risk matrix (particularly with regard to credit risk) which the insurance market provides and which for a considerable number of years, although can be used (a) to transfer risk and (b) as a capital the appetite and the use of these products mitigant. to arbitrage capital and insurance premiums has, in our experience, increased significantly. Trade credit insurance

An insurance against the possibility of a debtor failing to pay its debts (e.g. accounts receivables). Trade credit insurance may be purchased to secure the credit risk of a single structured transaction or a book of risks. Often an element of political risk cover may be incorporated (see below).

Protection is provided against: n Non-payment due to commercial Contract frustration insurance provides cover for risks (frequently the insolvency of the buyer). companies when they suffer losses as a result of n Late payment (or protracted default the contracts to which they are a party becoming of trade debts) and/or surety impossible to perform due to a frustrating event. default. The policies will frequently provide for a period in which debts JOHN BARLOW are to be paid once a default has occurred, failing which an indemnity will be paid i.e. a waiting period. by a private company (when caused n An agreement which relates directly by a political event) can threaten a to the financing of such specified Three features of key importance: company’s contractual rights and its contracts. ability to do business in a particular n Pre-qualifying requirements e.g. n An agreement concerning financing country. disclosure obligations, credit limits, which is secured against assets, retention of title clauses. Contract frustration insurance goods or services and/or payment provides cover for companies when for assets, goods or services n Reporting obligations e.g. they suffer losses as a result of the due under a specified contract or a spectrum of notification contracts to which they are a party contracts, or where repayment is to requirements ranging from becoming impossible to perform be effected by the sale or receipt of awareness of unfavourable due to a frustrating event. There is such goods or services. information to actual default. therefore a contrast with trade credit n Bonds provided within the terms n Obligations to minimise losses risk insurance, the trigger for which is of a specified contract, tender – issues may arise as to what crystallisation of a debt. Rather, the documents or project. constitutes reasonable steps and focus of contract frustration insurance preservation of subrogation rights. is a breach of contract, i.e. non-delivery In order to be covered, the loss must of goods. Nevertheless, it should be arise directly from one or more of the noted that the terminology which Contract frustration insurance following perils: attaches to these insurance products Companies that enter into sales is often used interchangeably – it is n A political force majeure event and trade contracts outside of common to find a contract frustration n An event resulting directly or their country of domicile will be policy insuring trade credit risk. indirectly from the actions, inactions exposed to cross border perils. and/or default of a government Acts of governments such as trade Contract frustration insurance may entity, including the inability to embargoes, import/export licence indemnify an insured for loss under the make a currency conversion cancellations, non-transfer of currency, following: and/or exchange transfer. Such unilateral termination of contracts n A specified contract or contracts for actions may also include default by governmental entities and non- the sale, purchase, lease or delivery of a government entity which is payment by a government buyer or of assets, goods or services. guaranteeing the performance of

02 Insurance/Reinsurance either another government entity or n Where commodities are concerned, to the payment of any claim. One of a commercial organisation. the interests of the bank and the method of addressing this issue trader which they wish to protect is to have the opinion addressed Political force majeure events include under an insurance programme to the insured and insurer (and, riots, strikes, civil commotions, may differ. Often when a loss possibly, the reinsurers). malicious damage, sabotage, occurs, a bank will wish to be n terrorism, war, invasion, acts of foreign paid immediately (rather than on The programme may not effect enemies, hostile action by national or the tranched payment dates) and the entire risk transfer (in terms of international armed forces (whether therefore the policy should contain capacity available e.g. there may be war be declared or not), civil war, provisions for the acceleration of limited capacity in terms of various rebellion, revolution, insurrection, amounts due (often this is at the jurisdictions) and therefore other military or usurped power, or other sole discretion of the insurer; these (non-recourse) facilities may need similar events. provisions should be removed if to be considered. Contract frustration policies may possible). Traders will be focused on n The broker’s offering should be protect against non-performance of a obtaining the underlying commodity scrutinised to ensure that they trade or sales contract by either party and will therefore wish to renegotiate have a security committee which due to political events. The cover may the deal and consequently there is capable of monitoring the (re) apply to: will be waiting periods, upwards insurers and replacing them, if of 180/270 days (the “waiting necessary, for example, if they fall n Pre-shipment risks: cover may period”). Again, attention should be below A – (S&P) (indeed, wording extend to costs incurred, such as paid to scenarios where the entire to this effect should be included in work in progress, raw materials, transaction is irrecoverable and the policy (and reinsurance) too). finished goods or engineering therefore accelerated payments design, up to the point of should be made. n Subrogation provisions should be termination of the contract caused scrutinised carefully – they will often n by the triggering event. Policies are rarely subject to legal usurp the standard understanding due diligence (e.g. warranties and for the application of recoveries n Post-shipment risks: coverage is conditions precedent are not picked i.e. uninsured element, insured provided for loss caused by the up or acted upon). Dilution of duties element, deductible (if any). Policies triggering event. should be negotiated and, where will often provide for the allocation the bank is a co-insured under of recoveries pro rata between Issues surrounding the use of the policy, non-vitiation and waiver insured and uninsured elements of insurance of disclosure clauses (Financier loss. If the entire exposure is not Clauses) should be inserted. covered then thought should be Whilst the demand for these insurance given to reverting to the traditional products is relatively sophisticated on n The nature of the bank’s interest “waterfall” application of recoveries the buy side, in our experience, the in the policy requires careful to ensure that the uninsured products which are made available consideration and legal artifices element is recovered first. by the market struggle to meet such as noting of interests and the demands of the buyers for the assignment of the policy and policy n Policies often fail to reflect the following reasons: proceeds should be considered minimum regulatory requirements carefully. (e.g. cancellation provisions, n Policy wordings are not bespoke payment timing provisions), and fail to recognise the underlying n There is often a requirement that which can benefit insureds when transaction. Attention must be the insured transaction/obligations addressing capital costs. paid to the underlying transaction are legally valid and enforceable. e.g. accelerated payments, which The failure to obtain adequate legal can cause significant issues when opinions (or seek a suitable dilution losses occur. of this requirement depending on the strength of the local opinion) can result in an absolute defence

Insurance/Reinsurance 03 How HFW can improve your mapped in to the insurance policy HFW has advised in connection with security and stress testing local law opinions the restructuring and rescheduling of as to enforceability. transactions as well as ensuring that Many of the issues which are insurance programmes support the identified above (and many ancillary We can advise on structured and reconstituted transactions. issues) have been considered by captive programmes (the latter are HFW in policy reviews conducted for frequently to be found where banks Our team has considerable bank, trader and commodity clients. are involved and, therefore, additional experience in recovering indemnities Our involvement encompasses issues will need to be considered given from insurers and reinsurers (notably reviewing the underlying contract the involvement of reinsurers and the by way of LCIA arbitrations) as well (where we bring to bear our degree of control which they may wish as securing recoveries in subrogation considerable and market leading to exercise, particularly in connection actions (for example, by way of commodities practice), ensuring the with the adjustment and payment of Bilateral Investment Treaties). relevant terms and conditions are the loss).

For more information, please contact John Barlow, Partner, on +44 (0)20 7264 8188 or [email protected], or your usual contact at HFW.

For more information, please also contact:

Paul Wordley Sam Wakerley Richard Jowett Partner, London Partner, Dubai Partner, Melbourne E: [email protected] E: [email protected] E: [email protected] T: +44 (0)20 7264 8438 T: +971 4 423 0530 T: +61 (0)3 8601 4521 Olivier Purcell Paul Aston Andrew Dunn Partner, Paris Partner, Singapore Partner, Sydney E: [email protected] E: [email protected] E: [email protected] T: +33 1 4494 4050 T: +65 6305 9538 T: +61 (0)2 9320 4603 Pierre Frühling Peter Murphy Julian Sher Partner, Brussels Partner, Hong Kong Partner, Perth E: [email protected] E: [email protected] E: [email protected] T: +32 (0) 2643 3406 T: +852 3983 7700 T: +61 (0)8 9422 4701 Dimitri Vassos Nick Poynder Jeremy Shebson Partner, Piraeus Partner, Shanghai Partner, São Paulo E: [email protected] E: [email protected] E: [email protected] T: +30 210 429 3978 T +86 21 5888 7711 T: +55 (11) 3179 2900 (Sao Paulo) T: +44 (0)20 7264 8779 (London)

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