Capital Treatment of Non – Payment Insurance – A Success Story

The Prudential Regulation Authority (PRA) has published a Policy Statement (PS 8/19) and updated Supervisory Statement (17/13 “Credit Risk Mitigation”, which will come into force on 13 September 2019) in relation to the use of different types of guarantees as unfunded credit risk mitigation (CRM) for the purposes of calculating capital requirements under the Capital Requirements Regulation (575/2013) (CRR).

Last year, the PRA published a consultation paper on this subject, setting out certain draft proposals which caused serious concern in the market. Key issues arising out of the consultation paper included:

• The PRA’s expectations that the provider of the credit protection must be obliged to pay the beneficiary bank “without delay and within days, but not weeks or months” of the counterparty’s default, conflicted with the typical waiting periods agreed in credit insurance policies and export credit agency guarantees.

• There was a lack of clarity as to whether credit insurance policies containing market standard exclusions, such as an exclusion for nuclear-related events, would be considered eligible where the operation of such exclusions is outside the strict control of the insured.

Members will remember that ITFA produced a lengthy response to, and comment on, the PRA paper as did a number of other industry associations.

The PRA has made a number of significant changes to its proposals in direct response to that feedback. Highlights include:

•  The PRA has decided not to implement its proposal in timeliness and acknowledges that there may be difficulties in applying a single measure of timeliness to all the different products that may be used as guarantees. This is positive news for banks using credit insurance and ECA guarantees, as the standard waiting periods for these instruments will not automatically render them ineligible as CRM.

•  The PRA advises that the nuclear exclusion may be contrary to the CRR requirements unless “in all circumstances the clause is immaterial to the guaranteed exposure and the risk of an obligor default under that exposure”. This means that a policy containing this exclusion can be eligible as CRM, where the bank can demonstrate that it meets this condition. However, there will still be cases where exclusions cannot be considered eligible and an assessment will still need to be made as to whether an exclusion is within the insured’s control.

•  The PRA considers that in some cases the use of guarantees as CRM has actually proved to be less effective than expected, resulting in residual risks. For example, where a dispute between the insurer and the insured has resulted in a lengthy delay in payment, or where the insured’s disclosure duty is “broad and vague”. In some circumstances the PRA will expect a bank to hold additional capital to account for these “residual risks”, even where an instrument meets the CRR criteria for CRM. This highlights the importance of careful policy drafting to reduce the practical risks of dispute and any uncertainty in the policy terms. Members have the benefit of the guidance we published in 2017 on CRR compliant non-payment insurance policies.

Marian Boyle, Head of Insurance and Dispute Resolution at our partner law firm Sullivan & Worcester UK LLP commented “An excellent result: evidence that concerted efforts by industry players can result in significant change. The PRA has clearly taken on board the many concerns the market expressed last Spring. The clear take away is that careful policy drafting is still key to achieving capital relief.”

The PRA’s updated position is a very positive step forward and addresses the serious concerns that arose out of last year’s consultation paper. ITFA is very pleased with the outcome whilst underlining the need for careful consideration and understanding of non-payment insurance products.

The publications can be viewed here.