Basel III Reforms to Credit Insurance in the UK and EU

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 of the reforms 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 achieved through a more nuanced approach to risk than is currently in place, including risk mitigation and specifically, for present purposes, an enhanced focus on capital adequacy and permitted mitigation arrangements.

The PRA announced earlier this year that implementation has been delayed until 1 January 2027, with a deadline of a further four years until full implementation by 1 January 2030. This allows the UK release timetable to marry up to the equivalent in the US, which in turn maximises the chance of consistency in the respective jurisdictions. The EU is also adopting a phased approach to launch between 1 January 2025 and 1 January 2030.

The role of credit insurance

One of the key developments for credit insurers and their insureds concerns how credit insurance can be used as a form of unfunded credit protection and, in particular, the extent to which credit can be taken, from a capital perspective, for the credit insurance.

We previously  set out, in our article looking at the Impact of Basel III for Credit Insurers, a summary of the existing regulations regarding unfunded credit risk mitigation. Very briefly:

• 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.

• Lenders are able to take advantage of various credit risk mitigation (CRM) techniques. These are split between funded and unfunded CRM.

• Unfunded CRM includes "guarantees". Guarantees can include credit insurance policies.

• 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. Moreover, one method of calculating capital relief lenders are permitted to use is the Advanced Internal Rating Based approach.

• This allows them to estimate for themselves the likely recoverability under unfunded credit mitigation (CRM) tools such as credit insurance policies. Crucially, they can assume, under their advanced internal model, that 100% recoveries under the insurance policies will be realised.

There are broadly two levers that determine how robust credit insurance is as unfunded CRM. The first are the policy terms. Does the policy provide broad enough cover and limit the coverage arguments open to insurers? Secondly, what is the risk of the insurer becoming insolvent and failing to pay?

The first of these (and in particular which exclusions and policy conditions are acceptable and which are not) has been an ongoing topic of some discussion in the market over the last 10 years or more. We have advised on areas such as the permissible waiting periods in policies, the interaction between the policy due date and the underlying event of default, the permissibility of cyber exclusions and the impact of coverage not fully extending to match the timing of underlying loan repayments where an insured has decided to accelerate the repayment obligations.

The second, however, has come to the fore in the minds of the regulators in particular in the UK and EU following the launch of Basel III.

The approach adopted by both the PRA and EU is as follows:

1. Credit insurance remains eligible as a "guarantee" and therefore as unfunded credit protection for the purposes of CRR capital credit.

2. The PRA are proposing to change this by removing the AIRB  approach for risk weighting exposures to insurers (and other financial institutions) and crucially taking away the banks' discretion to assess their recoverability.

3. Rather, the banks will be required to adopt what's called "prescribed FIRB LGDs" which means Foundation Internal Rating Based Loss Given Defaults.

4. Under the PRA's proposal: "the prescribed FIRB LGD for senior unsecured claims on an insurer would be 45%", which would be the "lowest LGD that could be substituted in the case of an exposure with credit insurance".

5. Converting that into non-Basel 3.1 terminology, this means that banks will need to assume a maximum recoverability of 55% of the value of the credit insurance policy (but can assume less than 55%) for the purposes of capital credit.

The EU is taking the same approach. In the EBA Report on Credit Insurance, the EBA note the "supervisory prescribed LGD value of 45%". Attempts to argue that credit insurers should be treated as more robust, and therefore deserving of being designated as better security, were rejected. For example, the suggestion that the Solvency II framework that applies to insurers, and governs the quality and quantum of reserves that need to be held by those insurers, should mean they are considered less likely to default, was rejected. The EBA noted that "...the 45% LGD value is equally binding for other financial sector entities for which comparable prudential frameworks apply...".

Somewhat frustratingly for the market, the EBA stated that since there have been no observable financial failures of credit insurers in recent times, it was not possible to test how robust suggestions were that policies would pay out first before payments to other creditors in an insolvency situation. Aside from the absence of tangible data, it also appears to have weighed on the EBA's mind that a sizeable proportion of creditors in the event of an insurer insolvency would be the vast pool of policyholders. This was seen as undermining the comfort that policyholders would be paid out first (or near to first) in line.

The PRA are implementing their approach through additions to the CRR Rulebook set out in near final rules attached to their Policy Statement PS9/24. The EU are doing likewise through Regulation (EU) 2024/1623 of the European Parliament and of the Council amending Regulation (EU) 575/2013.

Comment

It will be interesting to see how the insurance and banking markets respond to these developments. The last few years have seen an increase in insurers writing Risk Participation Agreements or other guarantees as opposed to credit insurance policies. Both qualify from a regulatory perspective as general insurance products under UK and EU regulation (for example under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001). But they are legally distinct. For example, there is no duty of fair presentation owed prior to conclusion of a guarantee and no rights of subrogation in the event of a payout. The co-surety/co-insurance positions are different too.

Whether or not a particular agreement is a guarantee or an insurance policy is a matter of substance not of labelling, and we have advised extensively on the differences over the last few years. It is not always easy to tell. If, though, the guarantees are unfunded, they should be treated in the same way as credit insurance: both are "unfunded guarantees" under CRR. In other words, from a capital relief perspective, the designation may make no difference. On the other hand, whether or not the changes to the capital relief rules prompt greater use of funded rather than unfunded risk mitigation techniques will be interesting to follow.

Furthermore, the PRA has said that if a different (and we infer more generous) approach was to be taken to credit insurance, this needs to be agreed internationally rather than just locally in the UK. This though raises the question: how will the Basel III credit risk mitigation principles be adopted in the US? It is noteworthy that whilst the UK and the EU are aligned, the US is far less so. If the US is a more benign territory for Insurers, it is possible that this could be used to leverage changes in the UK and EU over the longer term too perhaps?

We advise extensively on credit and political risks insurance and on risk participation agreements, bonds and derivatives. Please do not hesitate to contact us if you have any questions.

Credit Insurance and Risk Mitigation Solutions - core group:

Jonathan Thorpe (Partner in the Insurance Group, London)

Felix Zimmermann (Partner in the Insurance Group, London)

Olivia Delagrange (Partner in the Insurance Group, Madrid)

Niall Brophy (Of Counsel in the Insurance Group, London)

Elizabeth Mason (Counsel in the Insurance Group, London)

Joseph Wootton (Supervising Associate in the Insurance Group, London)

Rosali Pretorius (Partner in the Financial Markets Group, London)

John Sayers (Partner in the Banking Group, London)

David Toole (Partner in the Structured Finance and Derivatives Group, London)

Marcin Perzanowski (Partner in the Structured Finance and Derivatives Group, London)

Kate Cofman  (Partner in the Structured Finance and Derivatives Group, London)

Tommaso Canepa (Partner in the Financial Markets Group, Milan)

Jason Valoti  (Partner in the Financial Markets Group, Singapore)

Malcolm Smith (Of Counsel in the Financial Services Regulatory Group, London)