Credit risk insurance is a vital instrument for bank risk and capital management, and for facilitating lending to the real economy.
Typically, banks only use the strongest insurers with sound capital bases and risk management practices for credit risk insurance, but even so, some market participants argue that current regulations are overly restrictive.
One of those is Silja Calac, board member at the International Trade and Forfaiting Association (ITFA) and head of the ITFA Insurance Committee.
Calac’s insights are also drawn from her current role as head of private debt mobilisation in global transaction banking for Continental Europe at Banco Santander, and from her previous experience as a surety underwriter at SwissRe.
Jean-Maurice Elkouby, another contributor to the Position Paper, also serves on the ITFA Insurance Committee and is heading its regulatory working group.
His regular role is based in London, where he serves as managing director for credit insurance at ING Bank.
In this year’s first quarter, Elkouby and Calac played a leading role in delivering the committee’s latest Position Paper, which argues for greater leniency for insurers and banks in credit risk insurance, in the face of onerous Basel III and Solvency II regulations.
Credit risk insurance on the rise
ITFA’s latest Position Paper on credit risk insurance is the result of a wealth of research data and over two years of advocacy from the ITFA Insurance Committee.
In 2019 an ITFA survey calculated that an annual €600 billion of lending to the real economy is facilitated by banks using credit risk insurance.
More recently, in March this year, ITFA published the results of another survey conducted in partnership with the International Association of Credit Portfolio Managers (IACPM).
The survey found that the attractiveness of private credit risk insurance (PCRI) as a tool to mitigate credit risk has further grown since 2019, with 87% of respondent banks now using PCRI.
Moreover, as in ITFA’s 2019 survey, PCRI ranked second in importance as a market tool for risk mitigation by respondents, coming in behind secondary loan trading and ahead of funded risk participation.
Finally, the survey found that banks are increasingly using PCRI solutions across all asset classes – from corporate loans to asset-based finance and trade finance. The report also shows that the use of PCRI by banks to cover their Global Transaction Banking business is mainly from European banks.
And during the past two years, PCRI insurers have relieved respondent banks from close to USD 800 mln of credit losses.
Challenges to credit risk insurance: Basel III, Solvency II
As we can see from ITFA’s work with the IACPM, credit risk insurance is a key driver of lending to the real economy, and its importance is growing.
However, both Calac and Elkouby say that credit risk insurance is influenced by two regulations: Basel III (which applies to banks), and Solvency II (which applies to insurers).
Introduced in 2014 as a Directive in European Union (EU) law, Solvency II aims to ensure safe management of capital and balance sheets among insurers.
“Everything is designed to protect the policyholder,” says Elkouby. “That’s the first goal of Solvency II, and the bar is very high.”
“It requires that insurers keep capital for a one-in-200-year event, meaning they need to be able to cover any loss that could occur over the next year with a 99.5% confidence level.”
Basel III is a suite of capital requirement regulations that applies to banks. In the European Union (EU), Basel III was transposed into the Capital Requirements Regulation II (CRR), which was passed by the European parliament in 2019.
“The interaction of these two pieces of regulation is very separate, and they address different constituencies: insurers and banks,” says Calac.
“But credit insurance is actually arranging for the transfer of risk between banks and insurers, so we need to look at both to address this topic.”
As of January 1, 2025, Basel III will give way to an updated set of regulations known as Basel IV.
Why the Position Paper?
By adopting Basel IV, European regulators had hoped to create a level playing field among small and large banks, in order to ensure fair competition between them.
However, as noted by Calac and others at ITFA, Basel IV produced some unintended consequences for credit risk insurance products.
“This stems from the fact that an insurer can have two roles when interacting with a bank,” says Calac. “On the one hand, an insurer can be a borrower (when a bank lends money to an insurance company), and on the other, an insurer can be a protection provider.”
“And when the insurer acts as a protection provider, the bank becomes a priority creditor based on Solvency II.”
Despite that, as Calac points out, under Basel IV the same loss given default (LGD) rules will apply, whether a bank is lending money to an insurer or whether a bank is insured.
“We think it’s not justified, and it will have a serious impact on how banks can use the insurance product,” says Calac.
“Therefore, it will also have a serious impact on the €600 billion of lending to the real economy which is facilitated thanks to insurance.”
Understanding loss given default (LGD)
Loss given default is the share of an asset that is lost if a borrower defaults, and it is a key component of the equation by which banks calculate the value of their risk-weighted assets, as required by Basel III.
Other components of this equation include exposure at default, which is the principal outstanding on the loan, and probability of default (PD).
“It’s the combination of those three plus the maturity that produces the risk-weighted assets of a bank, and risk-weighted assets potentially mean more costs, or can be equated to cost,” says Elkouby.
Under Basel IV, senior claims without eligible collateral on banks would require a foundation loss given default of 45%.
But as Elkouby points out, 45% is a similar level to that applied by the European Central Bank (ECB) to leveraged buyouts, which are at the much riskier end of the spectrum compared with credit risk insurance.
“Again, it doesn’t seem right when you think that insurers are just as regulated as banks, both from a capital and liquidity point of view,” says Elkouby.
“So we have a series of arguments for why we feel that 45% is just not the appropriate level.”
Instead, ITFA proposes an LGD of 15% to 20% for unsecured insured exposures, and an LGD of 10% to 15% for secured insured exposures.
“These figures are backed by industry experience, seem reasonable and rest upon sound, evidence-based arguments,” the Position Paper adds.
Advocacy bearing fruit
After two and a half years of advocacy, Elkouby says the ITFA Insurance Committee made a breakthrough in the credit risk insurance space in October 2021, when the European Commission proposed a structured dialogue on the issue with the European Banking Authority (EBA).
This is enshrined in Article 506 of CRR III on the use of credit insurance as a credit risk mitigation technique, which will require the EBA to address the particular characteristics of credit insurance in terms of eligibility criteria and risk parameters.
“We’ll have to share a lot of data with them and have a number of discussions, but at least a first success has been obtained, and we welcome that dialogue that is ahead of us,” says Elkouby.