Bank executives may bemoan the recent rise in insurance premiums but banks stand to win business as innovative forms of credit and political risk mitigation are being sought in the banking and capital markets, says Melvyn Westlake.
Never particularly popular, the insurance industry is provoking a more than usual degree of vexation among bank and business clients. Bank executives and corporate finance directors have been shocked at the increases in many policy premiums that have landed on their desks in recent weeks. Sharp rises in premiums have been accompanied by tougher contract terms, reflecting a big drop in underwriting capacity across much of the insurance industry.
Unsurprisingly, the cost of cover against acts of terrorism has rocketed upwards - when it is available at all - since the September 11 attack on the World Trade Center. But readjustments in the insurance industry have affected many areas of specialised risk. Just when demand for political risk insurance (PRI) and credit insurance is rising, in the wake of high-profile debt defaults, such as Argentina and Houston energy company Enron, the amount of cover in those areas is shrinking. "It is the usual story," says one London banker. "The insurance companies run for the hills the moment they are really needed."
Risk mitigation
There is a positive side, however. Reduced insurance capacity is giving a big boost to alternative methods of credit and political risk mitigation in areas such as trade and project finance. On the one hand, exporters are turning to traditional markets, such as forfaiting - the discounting of trade receivables without recourse for non-payment. On the other hand, newer and more innovative forms of protection are being sought in the banking and capital markets, including credit derivatives and the securitisation of foreign trade receivables. Increasingly, credit and political risk insurance is used in selective combinations with securitisations and bond issues to mitigate risk and achieve a more efficient use of insurance than is possible from traditional policies.
In project finance, too, insurers are devising new techniques, with the banks, to isolate particular mixes of risks and lower the overall cost of risk management. Such combinations of capital, banking and insurance market techniques, known as alternative risk transfer (ART) or insurance-based investment banking, are significantly expanding the range of financing and loss-mitigation possibilities available.
Rate hardening
Even before September 11, a marked hardening in premium rates was already under way in the insurance industry, which is subject to distinct cycles of softening and hardening rates. Rising premiums attract fresh capital into the industry, eventually leading to competitive rate reductions, once again. "The insurance market had been on a down-cycle since 1997 but was hardening in 2001 as low returns encouraged reinsurers to rein in cover and jack up rates," says Charles Berry, chairman of BPL Global, a specialist trade credit and political risk insurance broker in London. "But September 11 created turmoil in the reinsurance market, exacerbating the hardening in rates."
Premiums for terrorism and sabotage insurance, which has been covered by general policy rather than specifically PRI, have risen five or six-fold, if available, according to David Cole, head of project finance at BNP Paribas in London. The current trend is for terrorism cover to be written as part of investment insurance in the specialist market.
Premiums for political risk insurance, including expropriation of assets by a foreign government or exchange controls that prevent an overseas buyer from making hard currency payments, are estimated to have risen this year by between 10% and 20%. The cost of credit insurance and comprehensive insurance (which combines both credit and political cover) is estimated to have increased by between 20% and 40% as a result of economic recession, the Enron default and rising insolvencies in both the US and elsewhere.
Insurance losses
Insurance industry losses (the collapse of the World Trade Center may cost it $50bn), together with a diminished appetite for risk and shrinking underwriting capacity, have contributed to the rise in premiums. Although there is evidence that the higher premium rates are attracting a new wave of capital into the insurance industry, this is unlikely to help specialty risk areas such as PRI for some time.
"In the mid-1990s, capital flowed out of property and casualty insurance, where rates were softening, and into the private PRI market [as distinct from government-run export credit agencies]," says John Minor, Chicago head of the political risk group at insurance brokers Aon. "Now, most of the new capital is going into the property and casualty market, where premiums are up sharply, by as much as 400% in some instances."
A number of reinsurers have pulled out of political risk insurance, in pursuit of higher returns elsewhere, according to Patricia Skold, global manager for PRI at Chubb, a New Jersey-based primary insurer. As a result, PRI and credit insurance are facing what she calls a "capacity crunch, just when there is far greater demand" for such cover.
The private market
In the private market, total PRI underwriting capacity for any single project is estimated to be down to about $800m today, according to BPL Global's Mr Berry. This is almost 50% below the $1.5bn available in 2001, although few companies ever offer their maximum line. The bulk of this reduction has been experienced at Lloyd's in London. At AIG, one of the world's largest political risk insurance companies, capacity is down 17%, at $125m for any one project, from $150m last year.
To some extent, the drop in available cover has been offset by weaker global business activity, as recession has cut trade and forced financiers to postpone projects. On the other hand, the New York terrorist attack - coming in the wake of the Asian crisis, the Russia debt default and rising Islamic fundamentalism - has sharpened perceptions of an increasingly risky world in which to operate. Ms Skold estimates that enquiries for PRI have doubled in the past couple of years. Faced with shrinking capacity, rising premiums and reduced tenors for political and credit cover, bankers, exporters, project sponsors and corporate investors are finding other ways, old and new, to mitigate risks. The export credit agencies (ECAs), such as the UK government's Export Credit Guarantee Department and the US's Ex-Im Bank and Overseas Private Investment Corporation, have long been the mainstay insurers of more risky medium and long-term international deals. Their services look set to see greater demand.
Reducing exposures
Insurance is only one of several alternatives for banks seeking to reduce their exposures. In the case of project loans, banks tend to use the syndication market as the principal method of spreading the risk. And, anyway, banks are going to be more selective about countries in which they are prepared to finance projects.
"Good emerging markets will still be able to get the money they want," says the head of project finance at one major European bank. "But the more difficult countries will find it a lot harder to get the financing that they need." Argentina and Venezuela are cited as difficult countries, although there is a good deal of disagreement about the extent to which Islamic countries in the Middle East are being affected by generalised concerns over political instability. European banks are said to be "more relaxed" than their US counterparts.
Meanwhile, at the shorter end of the international market, forfaiting activity is rising as a direct consequence of the increased difficulties that some companies face in getting political risk cover, says James Larkin, head of Aon Trade Finance, a subsidiary of Aon insurance brokers. "Forfaiting is an alternative to PRI. It is a bit more expensive than political risk insurance but the exporter gets cash as well as cover," he says.
The forfaiting market allows exporters to sell, at a discount, bills of exchange guaranteed by an importer's bank. Bills of exchange, and other trade finance assets, such as letters of credit and promissory notes, are traded in the market or bought for investment by third-party banks and portfolio managers. Once an exporter has sold the trade paper and received cash, the political and credit risk is eliminated as far as they are concerned.
Chance for new business
The rise in insurance premiums "is providing a window of opportunity for the banks to get new business, at higher margins than would have been the case a years ago, in direct competition with the insurers", says Mr Larkin. As Aon serves both markets, it is in a strong position whichever way the balance swings between the insurers and the banks.
If the restricted insurance capacity is giving a fillip to established banking markets, it is also giving a big push to newer techniques, particularly at the point where the capital markets and the insurance sector meet. One such point is the growing market in the securitisation of credit-enhanced trade receivables. Trade receivables securitisation is well established in the domestic US market. But securitising international trade receivables is more recent. Under this technique, a stream of 60-90 day trade receivables are placed in a conduit, providing the collateral for the issuance of commercial paper. The main aim is to raise finance, usually for three to five years, rather than to obtain risk protection.
However, because there is often a concentration of trade receivables from a narrow group of customers (say, two or three customers accounted for 50% of all outstanding receivables), credit risk cover is frequently needed from insurance companies for that lumpier part of the deal. Similarly, if the source for a significant portion of the receivables is located in a politically uncertain country, insurance may be required to cover the risk of currency non-convertibility, for instance. This enables the transaction to obtain a credit rating, usually triple-A, that is higher than that of the issuer. The difference between this kind of insurance cover and the more traditional monoline bond insurers is that the latter usually only accept the better investment grade risks. In contrast, a trade credit insurer, such as Gerling NCM Credit and Finance, which has a history of assessing foreign credits, is prepared to consider risks at the very bottom of the scale, even potentially down to triple-C, says Mike Holley, director of the company's financial solutions division in London.
At the same time, the sort of insurance enhancement offered by Gerling NCM Credit and Finance - created in December by a merger of NCM, the Amsterdam-based credit insurer and the Gerling Credit Insurance Group in Cologne - is cheaper than buying credit derivatives, which Mr Holley describes as "a sledgehammer to crack a nut". This is because the most liquid part of the credit derivatives market is for five-year tenors. "So you have to buy five-year protection for a 60-day asset," he says.
Of the $200bn of outstanding securitised trade receivables, Mr Holley reckons that some $4bn-$5bn have been enhanced by the use of credit or political insurance. This kind of activity, which started in the late-1990s, has doubled in the past couple of years and is set to rise sharply, he says. So far, around 20 or 30 deals are thought to have been done. Apart from Gerling NCM Credit and Finance, which is 25% owned by Swiss Re, other firms involved in the market include AIG Global Trade & Political Risk Insurance (a subsidiary of the huge US general insurer) and Hermes (the German trade credit insurer).
Although these types of capital markets transactions depend on the insurance sector, they do not represent an alternative to it, but they do have the benefit of making the available insurance capacity stretch further. Some insurance companies are also believed to be considering securitising their portfolios of risks and selling them to the capital markets, instead of simply buying reinsurance in the conventional way.
Political risk insurance
A number of public and privately placed bonds issued by emerging markets companies have also been enhanced by political risk insurance. About $2bn-$3bn of such deals can be expected in 2002, according to Daniel Riordan, executive vice-president of Zurich Emerging Markets Solutions (ZEMS) in Washington DC. ZEMS is a subsidiary of Zurich Financial Services Group, one of the world's largest providers of political risk insurance. Focusing chiefly on infrastructure companies and the banks that finance them, ZEMS has provided PRI for more than $2bn for bond issues in the past 30 months, including four offerings by Brazilian companies, including Petrobras.
Risk coverage
The shortage of PRI capacity in general is spurring demand for the kind of efficient solutions that ZEMS is offering, says Mr Riordan. The key to the structures that his team has devised is that companies only need to insure part of their bond issues. A 100% PRI cover for, say, $500m issue is unnecessarily conservative for a long-term bond because most events that disrupt payments tend to last between 12 and 24 months. So risk coverage needs only to reflect this, he says.
For example, it may be necessary to insure only $50m of a $500m issue (covering, perhaps, only interest payments and not repayment of principal), although the issuing company is usually also required to create a debt service reserve account where it must lodge six months' worth of payments on the bond. Such insurance cover would still allow the company to get a credit rating higher than that of its home country and therefore permit it to issue the bond more cheaply. The 25-50 basis points cost of the PRI plus other fees would usually be more than offset by a saving (of, perhaps, 100 basis points) on the interest that is paid to investors, according to Mr Riordan. This is a highly effective use of risk insurance that is attracting other specialist insurers into the business, he says.
ART techniques
However, the range of techniques that fall under the ART rubric extend well beyond credit-enhanced or PRI-enhanced capital market issues. Tom Skwarek, London-based head of Capital Solutions, part of Swiss Re's Financial Services Business Group, says that political risk is often wrapped up with the whole economic viability of a project in the higher grade emerging markets. An oil platform in the Gulf of Mexico, for example, would have a variety of risks, ranging from the problems of physical construction to a catastrophic interruption in the oil flow or a slump in the oil price. The insurance companies will form a syndicate to cover an agreed mix of risks. "Most insurers today do not look at wrapping the entire deal. There are more efficient ways to uses the insurance industry's capacity in the public markets. Our aim is to work in a complementary way with the banks," says Mr Skwarek.
In some instances, ART techniques switch the insurance company's role from traditional insurance underwriter to potential investor. For example, they might make a commitment to provide additional capital to the project if pre-agreed adverse events occurred. The commitment is designed to protect the project from a temporary cashflow interruption due to unexpected material adverse events. There is a commitment fee for the promised capital but, if the capital is used, it becomes an investment. "This gives us an opportunity to obtain a return on our investment, whereas normally insurers collect a premium for taking a risk and do not get their money back if the event occurs," says Mr Skwarek. Because the insurance company has a chance to recover its money, the commitment fee is less than a normal premium would be. "It does not make sense to pay a very high premium for a low probability risk, especially if the project can recover from some terrible event," says Mr Skwarek. The general hardening of the insurance market since last year may leave bankers and company executives fulminating against much higher premiums but it promises to stimulate much new innovation in the financial markets.
