Column: Non-traditional credit (re-)insuranceexploring the path ahead

Author: Sascha Dear, R+V Re

The rich history of credit insurance traces back to the 1600s in England, when the first known credit insurance policy was issued. Over time, it gained popularity with the growth of international trade in the 19th century. The establishment of the German “Hamburg Credit Insurance Association” in 1848 marked a pivotal moment for credit insurance, when the idea quickly spread throughout Europe and North America. Numerous credit insurance companies emerged, offering services to mitigate non-payment risk for their customers. During the 1970s and 1980s, as global trade further expanded, credit insurers extended their coverage to include political risk insurance, safeguarding businesses operating in politically unstable regions. Today, credit insurance is a key component of the global trade finance industry and is used by businesses of all sizes to manage credit risk and protect their balance sheets.

The first credit REinsurance contract was signed in 1892 between the “North British and Mercantile Insurance Company” and the “National Credit Indemnity Company”. This marked the beginning of credit reinsurance as a recognized product in the insurance market. When in the early 20th century global trade flourished, credit reinsurance gained traction due to increased demand. Today, credit reinsurance serves as an essential risk management tool for credit insurers, enabling them to mitigate their risk exposure effectively. The growth of global financial markets and the rise of complex “non-traditional” financial products have further driven the demand for credit reinsurance. Consequently, credit reinsurance has evolved into a mature and highly specialized industry.

In the traditional credit insurance world, which, for historical reasons, is dominated by Surety and (Whole Turnover-) Trade Credit products, we (whenever I use “we” in this article, I refer to both, insurers, and reinsurers) use various credit risk models including Merton, KMV, CreditMetrics, Jarrow and Turnbull, SFAA, among others. These models have been tested and refined across multiple cycles, providing a level of comfort in assessing risks, determining risk appetite, and meeting regulatory capital requirements. And to also provide significant amounts of credit insurance and reinsurance.

So over history, we have adapted to and were able to cope with the then existing challenges. However, the landscape has undergone significant transformation in the past decade. As an example, six years ago, “minor issues” at one of the world’s largest Export Credit Agencies (ECAs) paved the way for Aircraft Financings to land in credit insurance markets, and subsequently, insurers found their way into spaces traditionally occupied by the banking sector. Quickly the banking sector realized that, for them to keep pace with evolving regulations and increasing regulatory capital requirements, the insurance sector can be a quite reliable partner. So, the Holy Grail of “Capital Relief Transactions” found a new home in the non-traditional credit insurance industry. With the broad introduction of Synthetic Risk Transfer (SRT) products into the insurance space in 2019, portfolio-solutions marked the next evolutionary step. Presently, terms like Warehousing Facilities, Net Asset Value-financings, Receivable Finance Portfolios, CLOs, Subscription Line Financings, Capital Call Facilities, NonRecourse-Transactions, Blind Portfolios, Repacks, AssetBased Finance transactions (often accompanied by corresponding swap-facilities), PIK-Financings, “Balthazar”, Diversified Payment Right-Transactions (“DPRs”) and 25-year-Project Financings have transformed into common offerings. And again, insurers and reinsurers are adapting to this expanded spectrum of non-traditional credit insurance products.

Today, these rapid changes coincide with an unprecedented combination of challenges: the COVID pandemic, supplychain disruptions, geopolitical tensions (e.g., Russia/ Ukraine crisis, Taiwan), global inflation coupled with interest rates not witnessed in decades, recession forecasts, cybersecurity concerns, rescue packages for banks, ESG considerations, new accounting principles, etc. Although the impact of COVID on global credit default rates proved less severe than many of us anticipated, the uncertain credit insurance and reinsurance environment is likely to persist for some time.

To keep up with the momentum of expansion of the non-traditional credit insurance space in a constantly evolving world, it is very important to adapt swiftly to these challenges. Which itself presents a challenge due to the scarcity of empirical data available for simulating and stressing PD- (Probability of default) scenarios, when compared to the more traditional products. So, to gain comfort with these new products, we must rely on the expertise and empirical data provided by banks, asset managers, and specialized NFIs (non-financial institutions) & DFIs (development finance institutions), who have been operating in this specialized niche for much longer than we have. Fortunately, there has been a positive shift in transparency, with lenders and brokers being more open to sharing information and models with insurers and reinsurers. This increased collaboration is a significant step forward, but we must further consolidate our efforts to effectively tackle the challenges of tomorrow. It is important to determine our general risk appetite for these types of transactions, which depends on us being comfortable with them. However, how do we become comfortable with something new? It requires us not only to identify but also to create our own models for quantifying the risks associated with “new” products. Additionally, it may be necessary to challenge existing models to ensure they remain effective in this evolving landscape.

The non-traditional credit insurance sector often deals with unique underlying assets, requiring a distinct skill set for analysis. A thorough analysis is crucial, allowing us to be well-prepared for when confronted with unexpected “Black-Swan” events. Full transparency to the lender’s documentation is mandatory, as it enables us to virtually re-underwrite the transactions. When the availability of information is limited due to the existence of nondisclosure agreements (NDA), reaching to the very same conclusions as lenders who use 100% of the information to seek approval from their credit committees, becomes challenging. This becomes particularly important when we are dealing with lenders’ portfolio solutions for capital relive purposes. Lenders use capital relief products to manage and usually reduce their risk-weighted assets (RWAs) by millions, sometimes billions, ultimately freeing up substantial amounts of Tier-capital within a banking corporation. Therefore, it is of paramount importance to approach such figures with the utmost diligence and caution, irrespective of the transaction structure. Please do not get me wrong, there are benefits within such (sometimes even heavily-) structured solutions, but that does not make the underwriting process easier.

While insurers primarily rely on reinsurance to manage their risk exposures, banks have a range of options available, such as secondary market transactions, true-sale arrangements, and securitizations. These options provide additional strategies for effective risk management. Though, it is essential to question whether we are also the most suitable partner for all transactions presented to us? This is particularly relevant considering the growing demand for exclusions such as, among others, RACE-Free (I call it the “Race for RACE”) or War-Exclusions? Attention should be given to the lender’s buying strategy and ultimate retention to assess the level of “skin-in-the-game” and the alignment of interest.

In my opinion the non-traditional credit insurance market will continue to expand its offering and will further grow to accommodate increasing demand from banks. Regulatory bodies are constantly working towards creating a more sustainable and resilient global banking sector, an ongoing endeavour akin to “The Neverending Story” which will fuel this development. The key to success in this dynamic credit environment is to always maintain an open mind, a calm and focused approach, robust models and a welldefined risk appetite. Although risk is inherent, the closer we are sitting together, sharing ideas and collaborate, the more comfortable we will become with underwriting it. … Or not.

As for the future, who knows what it holds? Perhaps we will witness a demand for innovative surety products designed specifically for mining rehabilitation in space colonies? Or heavily structured crypto-currency based supply chain transactions in combination with contractfor-differences perils? While the trajectory of traditionaland non-traditional credit insurance remains uncertain, one thing is certain: we will gather once again to comprehend the particulars of risk to become comfortable with it. After all, taking risks is what we do! And as stated in Martin Scorsese’s “Wolf of Wallstreet”: “Risk is what keeps us young”. However, I would add that fully comprehending the complexities of underlying transactions can sometimes lead to headaches.

In the upcoming edition of the Insider Magazine, Renate Kerpen from DEVK RE accepted the nomination as a columnist.

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