Global Trade Review Featured Article: Insurance – Policy Flaws Don’t get flawed!

Your insurance policy could likely be very badly flawed, claims Robert Piller, Director at Aupres Consulting in Geneva. He comes to an early conclusion that the insurance market continuously fails to provide effective policies to banks. 

Your policy is flawed, very likely badly flawed.

As an independent advisor working with banks to make trade credit and political risk insurance (TC-PRI) policies more effective risk transfer instruments, I can only come to one conclusion: the insurance market continuously fails to provide effective policies to banks.

Up to 80% of policies have material flaws that could render the coverage ineffective. Worse, up to 50% of policies exhibit fatal flaws, ie, there is a contradiction between the policy language and the underlying transaction structure or documentation such that the likelihood of the policy responding is so diminished as to be effectively invalid.

My conclusion is based on analysing several dozen transactions. My transactional database is statistically significant and covers a broad spectrum of transaction structures such as trade finance, receivables discounting, structured commodity finance, project finance, mining finance, and borrowing base facilities.

No guarantees
This is not necessarily to say that the policies will not perform in the event of a default; a policy may respond despite its flaws as an underwriter might recognise, either through negotiation or perhaps under the threat of legal action, the incongruous or unfair nature of the flaw. Might, but there is of course no guarantee.

The policy essentially becomes an option held by the underwriter: depending on the circumstances at the time of default, will the underwriter opt to exercise one of the possible defences generated by the poor design of the policy wording vis-à-vis the underlying transaction? One can well imagine that if an underwriter is being pursued by Elliot Spitzer, facing large claims from a California earthquake, Florida hurricanes or Pacific tsunamis, the likelihood of that option being exercised rises exponentially.

To be sure, TC-PRI policies are not the guarantees or risk participations that banks prefer. The fact that they are instruments governed by insurance contract law (I refer to English insurance law) ensures that the purchaser of cover is subject to some basic level of operational risk imposed by specific legal principles such as ‘utmost good faith’ whereby the insured is obligated by law to make full and proper disclosure of all facts that are material to the underwriting decision. Failure to do so relieves the underwriter of any liability. Even if the policy had no warranties or conditions, the presence of this requirement in law places the insured at risk of non-performance.

Yet, how is it that TC-PRI policies are and continue to be so flawed? One key factor is that TC-PRI claims are in fact relatively uncommon occurrences when compared to property or marine insurance. Much policy wording remains untested and if tested, the results are not transparent for most users of TC-PRI given that policy disputes are either settled or if pursued legally, subject to arbitration where decisions are not open to public review. Thus there is a lack of legal impetus to impel policy design. But to address the question fully, we must look at the culpability of all parties involved in a transaction: banks, underwriters, brokers and lawyers. Some part of the responsibility resides in each player.

For too many banks, TC-PRI is a ‘tick-the-box’ exercise. The policy is a credit enhancement mandated by the credit committee or country risk management team and not necessarily read or studied in detail by the transaction team. The credit risk management team often does not have specific knowledge of TC-PRI policy and market practice. Further, the insurance is often an afterthought and the market is approached later rather than earlier in the development of the deal.

Lawyers look at the legal sense of policy clauses, but usually lack the context of TC-PRI market practice to make a commercial analysis of the policy wording and thus overlook numerous residual risks.

One would expect underwriters to prefer to have options built in and therefore not be enthusiastic about proactively changing policy wording unless the insured takes the first step. Underwriters send out standard policy forms, usually through brokers, which they are happy to sign as is unless the prospective insured asks for amendment.

The broker performs two roles: (1) finding and placing capacity; and (2) designing the risk transfer instrument. The former is emphasised over the latter. Certainly I have never seen an up-front broker analysis on behalf of the bank of the many material issues when the policy is drafted and delivered. From my experience, I would maintain that most brokers, though legally the bank’s agent in the insurance market, do not understand well enough the banks they represent and are not familiar enough with facility documentation to design more effective risk transfer instruments.

And while the insured’s legal representative, the universal perception by everyone outside the insurance market is that brokers in fact represent the underwriters’ interests more than they represent the insureds’. I would say that the state of policy wordings proves that this perception is a defensible one if not indeed the correct one.

On balance then, we must assign the much greater part of the responsibility to the insurance market as they are the specialists in their product. The general insurance philosophy, however – and one arguably emanating from the spirit of insurance law which places so much onus on the insured – renders the insurance market passive in making hard policy wording analysis on a transactional basis. Hence, it is the insured who must initiate policy changes.

Residual risk and options: expropriation example
Let’s say that your bank has a customer in the energy area. You are financing a US$100 million power project in an emerging market that privatised its energy sector in 1997. You have required PRI-lenders’ interest policy as part of the security package. Two years into the project, a new radical government expropriates it, the ministry of energy and industry decreeing that energy is too important to be left in the hands of foreigners.

Compensation is not prompt, adequate, nor effective. In fact there is no compensation at all as the government says that the project earned returns in excess of what it should have at the expense of the people. Your borrower ran a nice project, following all the rules and regulations.

In addition, five other foreign companies have been operating in the energy sector. All are expropriated as the entire industry is renationalised. This proves the event is a bona fide expropriation. You can rest assured that you are clearly covered for an expropriatory act as defined in your PRI-lenders’ interest policy.

Can you? Take out your PRI-lenders’ interest policy and read the ‘non-discriminatory measures’ exclusion along with your underwriter’s in-house rottweiler of a lawyer. A typical example reads:

“The underwriters shall not be liable for loss caused by or resulting from non-discriminatory measures of general application of a kind that governments take in the public interest for the purposes of ensuring public safety, raising revenues, protecting the environment or regulating economic activities.”

Your borrower was one of six foreign investors to be expropriated, so the measure was not discriminatory to your financed project. And the action to regulate the energy sector is certainly one of general application taken in the public interest (as that government has defined this interest). Further, it is taken in order to regulate economic activities. This situation meets the essential requirements of the exclusion. You have a residual risk you may not have recognised in your pre-closing analysis: a clear case of expropriation that is not a clear case of an insured expropriatory act.

Your underwriter holds an option to invoke this exclusion or not. Eliot Spitzer is moving in, the hurricane has expended itself, the tsunami wave has receded back into the sea, and insurance loss adjustors are now out and about, estimating losses in the billions. You have just submitted your claim. Will the rottweiler exercise his option?

And this is only one of several ‘options’ that may exist. In my work, it is fair to generalise that the fatal flaws I have identified are usually related to a failure of the policy to conform to the underlying transaction’s structure. This is frighteningly common, as the 50% ‘fatally flawed’ category suggests. While it is more likely to occur in PRI-lenders’ interest policies covering complicated project financings, it is still disconcerting to see how often it can be found in respect of trade-related transactions.

The simple function is that the more structured and complicated a transaction is, the more likely there are fatal or material flaws in the policy. It even happens, as it did in a recently reviewed transaction, with a fairly vanilla structure. I have and continue to develop a ‘policy effectiveness rating’ system. I provide my bank clients an initial assessment and a revised one after negotiations are complete. The assessment identifies the residual risks inherent in a policy, offers solutions where possible, and assesses the impact of the residual risk on the coverage.

Adverse selection
For decades, the insurance market has complained that banks and corporates practice adverse selection against underwriters. When I was an underwriter with AIG more than 15 years ago, I too railed away at the world for practicing adverse selection against me. My experience since then has made me realise that in fact the financial and risk managers of the world are practicing rational commercial sense if they only use insurance to a limited and selective extent.

In respect of banks, a bank asks no more of an insurance company than it asks of another bank, or is asked of itself: a risk participation entered into on the basis of the participant’s own assessment and analysis of the risks involved and not relying on the risk seller. Insurance of course turns this principle on its head as the underwriter only enters into a transaction based on the representations and disclosures of the bank.

When I was finance director of a trading company, I needed credit lines, LC issuance, LC advising and confirmation, structured financing, inventory financing, receivables discounting, risk sharing. I got all of this from my banks. I only got a conditional risk sharing from my insurer, and I still needed to find funding. So of course I would canvass my banks first, rather take a limited recourse facility from a bank that combines funding and risk sharing, before turning to the insurance market.

I would argue that I was acting in a completely rational and professional manner as a risk manager. There is no adverse selection; there is adverse product offering. The policies are deficient compared with other alternatives, but that is what the insurance market chooses to offer in the belief that somehow they are protecting themselves.

Follow through with remedies
Identifying remedies is relatively simple and they are probably already widely acknowledged. The real challenge is to follow through. The Basel II world should start to set thinking in this arena straight and be the driver in this process. No longer will policies be hidden in the darkness of desk drawers to be pulled to light when there is a problem. The prospect of regulatory capital relief under Basel II will make the effectiveness of policies more of an on-going usefulness even if a policy never has to be called. After all, capital is the scarcest of resources and saving it must be a powerful motivation.

There are remedies. For banks this is to stop ticking boxes and to take control of the entire TC-PRI process; to start reading policies with knowledge of TC-PRI as a risk mitigation instrument. While some already have specialists on staff in this particular area, it would be necessary for a number of banks to invest in some further TC-PRI expertise, not for the front desks, but for the credit committee. To pay for this investment, it is surprising how many banks still do not realize that they can negotiate the commission with their broker (typically 20% in the London market). Commissions are not private matters between the broker and underwriter, but are part of the commercial relationship between the broker and the bank.

For lawyers: it is less obvious to see what lawyers can do given that there is a limited volume of PRI business. Their primary function will always be to analysis the legal sense of clauses and it there will only ever be a few lawyers who grasp it all. But some additional investment in expertise for certain law firms could make sense.

For underwriters: to embrace more fully that banks are underwriters and distributors of trade and project finance risk and are professional managers of this sort of risk. A natural partner really. To finally come to terms that there is no such thing as ‘adverse selection’. A better product will result in better business.

For brokers: as with easyJet and DirectLine auto insurance and any number of similar situations, the remedy is to eliminate the middleman, especially in the area of TC-PRI. The logic is simple. DuPont builds and operates a chemical plant in order to make products that it sells to its customers and not to enter the property risk and insurance market. The property risk incurred is incidental to DuPont’s ultimate business purpose, so working with a broker specialised in property risk could be a benefit.

As trade and project finance and their risk management are core bank activities, the broker certainly cannot know more than the bank and therefore can never represent the transaction to the underwriter better than the bank. Conversely, as the broker needs underwriter approval for any wordings used, the broker cannot represent the policy better to the bank than the underwriter. So what does the broker bring? Do they fully earn the 20% commissions? Brokers are an insurance imposed institution. Banks sell much more risk to other banks, and sell it to many more banks than there are TC-PRI insurers. Often the financial instruments are much more complicated than TC-PRI policies. And there are no bank brokers involved. A number of banks already do deal directly with underwriters. Brokers are entrenched in the landscape, however, so I certainly do not predict their exit any time soon. So the challenge for brokers is to raise their games on behalf of their clients.

It is high time for banks to start getting what they pay for. I have just finished analysing a policy for a bank client. The policy rated as ‘fatally flawed’. The original policy for the project was issued two years ago, thus premium had been paid for a policy that might never work. I recommended 22 policy amendments, including remedying the fatal flaw. The underwriter accepted 20 of the changes, or 91%, and the fatal flaw was remedied. The policy is now a workable risk transfer instrument providing broader cover to the bank.

As has been said in a number of forums, including Exporta conferences as well as in GTR, Basel II should create a glare on TC-PRI in a way that has never happened before. More of the flaws will be exposed. And ultimately remedied. The opportunity, if grabbed, exists for TC-PRI to become more relevant to a broader range of banks. It shall be interesting to see how it all plays out.

This article appeared in the May/June 2005 issue of Global Trade Review-GTR. To read the response by insurance brokers to this article read the July/August issue. To request your free sample copy, email pgubbins@exportagroup.com.