The chef's art - A broker's view on unfunded risk transfer

Feature | 8 August 2017

Susan Ross and Stephen Taylor share a broker's view on unfunded risk transfer in the London market

More banks are buying insurance against credit and political risk (CPRI), making wise use of insurers' capital rather than their own capital, and avoiding the need for bank syndication. This insurance market for 'unfunded risk transfer' has expanded hugely in recent years, responding to banks' demands.

The drivers for purchase of cover by banks are (1) risk management, (2) credit concentration (reducing the impact of 'spikes' in portfolio) and (3) 'capital optimisation' which is where the bank uses the insurer's rating to improve its risk weighted asset (RWA) calculation.

The CPRI market is driven by brokers who are encouraging a trend for improved insurance products, more capacity, and more effective policy wordings, drawing on experiences both in the single risk market and 'whole turnover' or portfolio covers. Where purchasing decisions are driven by finance there is opportunity to arrange extensive limits at affordable prices and for the broker to fine-tune wordings.

Here we discuss how the CPRI market is changing in that more placements are syndicated and policy wordings are being extensively reworded. Both of these are arguably driven by regulation. The more extensive flexibility is found in relation to the best risks, in particular where a finance house is simply using the policy to improve the cost of finance.

Where has this extra capacity come from?

There are more credit and political risks players in the London market as underwriters broaden their risk portfolios from general insurances into specialist areas. Regulation has played a part. Capital adequacy regulation in the form of Solvency II for European insurers, which came into effect in January 2016, led to a trend for general insurers to take on a wider spread of classes of underwriting in their portfolios.

The CPRI class is attractive because the risks are, by their nature, well spread. With nearly 200 potential destination countries, each with its own geography, politics, industries and natural resources, the politics and economics of those that are active in international trade in themselves make a spread portfolio. This contrasts well with property insurances where a 'torpedo' loss such as a hurricane, earthquake or flood can have a huge impact on insurer profitability.

Although sizeable insurers, where they like a risk, will put down very large lines, the number of newer insurers writing a small line of CPRI have brought down the average line size. This potentially means a greater number of insurers are needed for a big risk. A policy structured a decade ago would have had a lead insurer comfortable taking a large portion of the risk, and followers topping up the same 'slip' on the same rates and terms. Competition law, and Bipar [the European Federation of Insurance Intermediaries] rules on 'look ups' and 'look downs' lead to insurer participants annotating separate copies of the slip which the broker then amalgamates. Each underwriter is invited to agree the client's target rate and terms, and, where capacity is tight for more difficult risks, each insurer can in fact be underwriting at a different premium. In such arrangements, the broker creates a policy that is 'verticalised' where each line in a syndication is priced and invoiced separately.

Figure 1: Number of active underwriters in the London insurance market for Contract Frustration and unsecured credit (private buyer) 2011-2017

Source: Aon UK Ltd

Are we being overtaken by detail?

Notwithstanding that the policy may involve separate pricing for each line, a single wording is very necessary. The policyholder has to administer the policy, and, where the bank is not the primary policyholder, finance may need to be organised on the back of it, so it is vital to have certainty about what is covered, what is excluded, and any reporting requirements. It is also vital to 'personalise' the wordings to suit the risk, the contract management and finance needs. Every insured will have different procedures and requirements. In particular, amendments may be needed to enable the policy to be treated as an eligible guarantee for favourable capital treatment.

Brokers like negotiating wordings: they are a vital part of their intellectual property. But by doing this, the broker is also making a rod for his own back. With each wording being individually crafted, the process slows down. The broker has already negotiated premium rates, arranged the sharing of documents, and helped with selection of the insurer by reference to pricing, ratings, or existing insurer relationships. Draft wordings then have to go to and fro from the broker to the underwriter panel, and to the insured and the insured's lawyer to be checked. The financier will have strict needs in relation to bank regulation and capital adequacy. All this effort of rewording plus checking the minutiae of word-processed documents for mistakes in numbering and cross-referencing is leading to brokers creating their own basic wording, and obtaining clearance simply for the 'personalisation'.

Traditionally the whole turnover market has solved this in its own way: each insurer has its own proprietary wording. Instead of negotiating a new wording each time, the focus for the policyholder/financier, supported by the broker, is on the annual renewal preceded by two to three months of concentrated review and negotiation of the wordings and endorsements.

Figure 2: Average market rates and line by year

Source: Aon UK Ltd

Steak or stew and convergence

The role of the broker can be compared with a chef, pulling together the ingredients to suit the client's requirements. Typically there are separate approaches to crafting individual policies for large juicy single situations (placed in the CPRI market) and for portfolios covering a broad range of contracts in an effective but responsive annual arrangement (placed with one of a dozen whole turnover insurers). Brokers are revising wordings to get the best of both these markets. The experiences that brokers have learned from the single risk market - permanent credit limits and reducing the number of exclusions for example to make the cover more easily used by finance houses - have spilled into the whole turnover market. Another trend in the whole turnover market is the delegating of authority to front line underwriters for larger clients so fewer decisions have to be passed up for committee approval. This empowerment, which is not new to the 'excess of loss' portfolio underwriting market, speeds the process.

Convergence is not just from the single risk to whole turnover. Single risk underwriters are having to agree to wording changes to allow their policies to suit policyholder practices, to reduce waiting periods for claims, plus take advantage of the economies of scale established through bringing multiple single risks into an maximum claims limit based on the probability of default of the portfolio rather than the aggregate of the individual limits. The competitive nature of the single risk market for 'top end' risks reinforces these moves.

The best risks presented to underwriters are those motivated by finance rather than those that are inherently risky, in other words where the insurance is used by a bank to enable a better return on capital. The market for medium-to-high risk has, however, tightened as a natural response to a batch of claims on marginal risks written in earlier years. For such risks it is a seller's market and insurers are pushing up rates, if they quote terms at all. Here, wording improvements are unlikely to be agreed.

And this brings us back to whole turnover cover which, in theory, involves insurance of an agreed portfolio of risk, the insurer taking 'the rough with the smooth'. It is still possible to 'tuck away' the likes of Ukraine risk as part of a portfolio involving OECD risk, however the likes of Venezuela and Zimbabwe will need extensive background information to support the application for cover, and the risk transfer most probably ends up being a combination of careful contracting, cash management, insurance and banking.

In conclusion, if a risk presentation is motivated by the cost advantage of the bank using the insurer's capital rather than bank capital, there are now excellent opportunities for cleansing the policy wording of conditionality. Even if companies and banks have reviewed the advantage of cover in the past, it is worth taking a good look now at how the insurance market can improve the cost of finance for a variety of asset classes from trade through to loan-based finance structures.

Susan Ross MBE is account director, and Stephen Taylor is head of capital and structured products, Aon Credit International

Box-out 1

Slip - this is the description of the risk that the broker uses when presenting a risk to underwriters.

Line - in a syndicated insurance placement, each underwriter will agree an amount of cover that he/she is prepared to accept.

Lead underwriter - an underwriter headlines the policy, typically writing a large line and agreeing the wording.

Follower underwriters - contribute to a syndicated placement, agreeing to accept the policy wording negotiated between the broker and the lead underwriter.

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