The impact of BASEL III for credit insurers

Summary

Proposed changes to the current capital requirements regulations will come into force in the UK and the EU during 2025. Credit insurance will remain a key source of credit risk mitigation and will continue to allow financial institutions to obtain substantial capital credit as a result.

This article was originally published by Nexus in their regular newsletter.

Background

The Basel III reforms to international banking standards were introduced in the period 2010-2017 in response to the global financial crisis in 2008. The aim is to ensure banks have greater financial resilience to economic downturns with, amongst other things, capital adequacy that correlates more accurately to the risk taken on by those banks. This is done by a more nuanced approach to risk, including risk mitigation and specifically, for present purposes, an enhanced focus on capital adequacy and permitted mitigation arrangements.

The PRA in the UK is in the process of producing amendments to the existing regulatory regime implementing Basel III with a view to implementation in July 2025. The EU regulations are being implemented in January 2025. The US has a similar timeline for implementation.

The Current Rules

The current capital requirements regulations (CRR) in the UK and the EU state:

1. Financial institutions (which we will refer to as “lenders”) are obliged to set aside capital, loss absorbing liabilities and liquid assets to cater for credit risk relating to their portfolio of in scope instruments/transactions.

2. They will use either a standardised approach or an internal model to determine the capital adequacy requirements that apply to their portfolio(s).

3. Lenders (whether using the standard model or an internal model) are able to take advantage of various credit risk mitigation (CRM) techniques. These are split between funded and unfunded CRM.

4. Unfunded CRM includes “guarantees”. Guarantees can include credit insurance policies.

5. CRR allows for “risk weighting” using CRM. This permits the lender to substitute in the credit rating of the guarantor/insurer for the obligor on any guaranteed/insured loan.

6. Articles 192 to 217 of the CRR set out the requirements that must be met for a funded or unfunded credit protection to qualify for CRM.

7. Article 194 states that the credit protection must be legal and effective, and that the lender must provide “the most recent version of the independent, written and reasoned legal opinion or opinions that it used to establish whether its credit protection arrangement or arrangements meet [this] condition…”

8. For Unfunded Credit Protection, such as credit insurance, the insurer/guarantor must be an “eligible provider”. Regulated UK/EU insurers will qualify as “eligible providers”. In addition, if the internal model is being used, the insurer must “have sufficient expertise in providing unfunded credit protection…”. They must also be subject to equivalent regulation to the CRR (which would include SII regulations) and must meet certain credit rating levels.

9. Articles 213, 215 and 217 contain key requirements for guarantees, including insurance policies.

   a. The insurance/guarantee must be direct and must be an explicitly documented obligation assumed by the insurer/guarantor. In insurance terms, this probably means that the insured should be the lender.

   b. The extent of the insurance/guarantee must be clearly defined and “incontrovertible”.

   c. The insurance/guarantee must not contain any clause, the fulfilment of which is outside of the control of the lender, which amongst other things (and focussing on the most material restrictions): (i) would allow the insurer to cancel the policy unilaterally; (ii) would increase the effective cost of the protection as a result in the deterioration of the credit quality of the protected exposure; (iii) could prevent the insurer from being obliged to pay out in a timely manner in the event the original obligor fails to make any payments when due; (iv) could allow the maturity of the policy to be reduced by the insurer; and (v) the insurance contract/credit protection contracts must be legally effective and enforceable in all jurisdictions which are relevant at the time of the conclusion of the credit agreement.

   d. A lender must have in place systems to manage potential concentration risk.

   e. The lender must fulfil any statutory and contractual requirements in respect of, and take all steps necessary to ensure, the enforceability of its insurance/guarantee under the applicable law.

   f. The insurance/guarantee must give the right to the financial institution to pursue “in a timely manner” the insurer/guarantor in the event of a qualifying default of or non-payment by the obligor.

   g. The insurance/guarantee must cover all types of payments the obligor is obliged to make or, where certain types of non-payment are excluded, the value of the insurance/guarantee must be adjusted to reflect the limited coverage.

10. Prior to and upon placement of a relevant credit insurance deal, therefore, the proposed insured financial institution needs to be comfortable that the cover is clearly defined and incontrovertible, will pay out in a timely manner upon default by the underlying obligor and does not allow the insurer to cancel for any reason outside of the control of the insured.

11. This has, in the past, raised a number of points of potential contention at the drafting stage. We set out below a few observations.

12. First, paying out in a “timely manner” does not mean immediately. Suitable waiting periods are permitted. Indeed, the PRA has made it clear that it is not minded to impose a requirement that payouts must be made within a period of days. It has, at least implicitly, recognised that waiting periods can serve a useful function to allow restructuring of deals and/or for performance by underlying obligors during an extended period. That does not mean that the waiting period can be open ended, however. Furthermore, it is always important to check the policy trigger on the one hand, and the definition of default on the underlying loan agreement on the other hand. Suppose a loan agreement defines default as non-payment on a due date plus 30 days. Suppose the supporting credit insurance policy provides an indemnity for non-payment on the due date, with a waiting period of 90 days. In fact, the time period between default and payment is 60, not 90, days. Note too that under Article 178 of the CRR, a default is considered to have happened if either the obligor is unlikely to pay or the obligor is more than 90 days past due.

13. Secondly, the regulatory approach does not circumvent the need for a fair presentation of the risk by the insured, since that is within the control of the lender/insured.

14. Similarly, terms that require the insured to retain a minimum self-insured percentage of the underlying loan(s) or which exclude liability in the event the insured has engaged in any criminal or corrupt activity or has failed to obtain necessary licences to issue the loans should not fall foul of the regulatory approach, since again performance in each case is within the control of the insured. The PRA has, however, raised concerns that other policy exclusions such as cyber exclusions or political or civil unrest event exclusions could be contrary to the regulatory requirements.

15. It is important that CRR opinions are suitably drafted to cater for these points. But they should not render it impossible for a law firm to deliver a suitable qualifying opinion.

16. It should be noted that EU regulators (at EU or local level) could take a different view from the PRA on the CRR requirements.

UK Approach

The PRA is in the process of publishing its “near final” rule changes following Basel III and following the publication of its consultation paper CP16/22 – Implementation of the Basel 3.1 Standards (the “Consultation Paper”). The PRA has recently published the first half of its response. The second half is due during Q2 2024.

In Chapter 5 of its Consultation Paper, the PRA sets out its proposals to implement the Basel III standards for credit risk mitigation for funded and unfunded protection. The PRA do not appear to be proposing substantial changes to the current CRR rules when it comes to qualifying CRM. In terms of the policies themselves (rather than the treatment of those policies), they note the following “minor changes” (as they call them):

• the introduction of an explicit requirement that the insurance/guarantee would only be eligible if it does not contain any clause that would allow the insurer/guarantor to change unilaterally the insurance/guarantee to the detriment of the lender;

• clarification that an insurer/guarantor can either pay the lump sum due from the obligor or assume the future obligations of the obligor in the event of a valid claim on the insurance/guarantee; and

• for credit insurance (including MIG), clarification that these can be treated as eligible CRM where the eligibility criteria are met, being treated as either a guarantee or a credit derivative depending on how the credit insurance functions.

EU Approach

The EU, on the other hand, has published its proposed final amendments to the EU CRR Regulations.

The Commission has introduced some minor amendments that have been introduced into Articles 201 to 217 of the EU CRR. For example, they have made it clear that where there is a clause in a insurance/guarantee which provides that faulty due diligence by the lender or the debtor cancels or diminishes the credit cover, that shall not disqualify the insurance/guarantee from being eligible.

It will, though, be interesting to see how the relevant local regulators in the EU view credit insurance as a CRM and, in particular, whether the UK and EU approaches diverge substantively over time.

Consequences for Credit Insurers

At this stage, we consider that the proposed changes to the CRR are likely to increase appetite for credit insurance as a guarantee, but should not of themselves require changes to credit insurance policy wordings. Developments around the treatment of exclusions and waiting periods should be carefully monitored. This is both to ensure that the wordings remain appropriate when concluded, but also to maintain the discipline to push back on wording amendments that are, in truth, not required but where the CRR are used by insureds and brokers as the reason for them.

We would also emphasise one further note of caution. At recent sessions attended, the PRA have been very clear to explain that credit insurance and other guarantees should be seen as substantive risk management mechanisms, and not just techniques to allow capital credit to be taken. The capital credit should, in the PRA’s view, be a by-product of the insurance/guarantee being a true risk mitigant. The capital credit is not the sole goal. This is, in our experience, the way the products are viewed substantively on by all sides. It is, though, important to maintain discipline around the language used in relation to credit insurance and guarantees to avoid the suggestion that this has been forgotten.