Keeping credit markets turning – Zurich

Stricter regulatory capital constraints since the 2008 financial crisis are making it more difficult for banks and other financial institutions to add credit risk to their books. As a result, insurance companies are playing a far greater role in facilitating credit markets. 

“This is the new game in town,” said Alessandro Castellano, Global Head of Credit Lines for Zurich’s commercial insurance business. “Credit insurance is a topic of great interest and a major challenge, but we can find solutions in the insurance market for clients,” he told risk managers and insurance buyers at the FERMA Forum 2017 in Monte Carlo in October.

Before 2008, credit default swaps were the preferred tool to protect lenders funding long-term projects such infrastructure development or construction. “Credit risk is a very basic risk: buy something today and pay tomorrow. But the seller needs a bank or an insurer to manage buyer’s risk” said Castellano.

Basel III bank capital rules introduced since the financial crisis years are putting pressure on balance sheets, he explained. “Credit risks are even more important than they used to be and banks are under regulatory pressure. It is not that banks have been unwilling to create new credit, they have just often been unable to do it. There’s plenty more for us to do, and other carriers: contrary to the banks, this business diversifies our portfolio” said Castellano.

Through large, tailored transactions, the insurance market can help reduce the regulatory capital held against specific financing transactions. Zurich has taken a lead in this regard, Castellano explained. “The question is how insurers and brokers can provide satisfactory solutions. There’s no one size fits all solution,” said Castellano.

Luigi Sturani, the CEO of specialty insurance for EMEA at Aon Risk Solutions, explained how such a solution was designed with Zurich to provide a financial institution with portfolio protection, backed by a credit rating that was high enough to allow a reduction in the regulatory capital required.

“The bank had a portfolio of short term credit amounting to about $1 billion,” said Sturani. “That portfolio was secured with traditional trade credit insurance. However, the ratings of the panel of insurers providing the coverage was not high enough to allow a lower capital requirement.”

Relying as a counterparty on its “AA-” credit rating, Zurich guaranteed the protection from any default among the portfolio’s original insurers. The insurer provided the biggest slice of $100 million protection out of a backstop totalling $1 billion placed for this deal.

“They were able to step in and secure the protection of the deal. In insurance terms, it’s a contingency cover,” said Sturani. “That makes for a stronger and more secure structure because of the higher rating of Zurich. In turn, that allows the bank to allocate lower capital to that portfolio.” 

Castellano described this as having a dual benefit to the customer. “There are the benefits for that specific transaction and for that portfolio, but it also free up capital for entirely new transactions, creating new opportunities” he said.

This opportunity is not confined to Europe but has global implications, he suggested, with the guarantee in the same currency as the portfolio. “The European Central Bank is stricter than some others. When compared to the US and Asia, there is more pressure in Europe for capital relief from banks. And most credit deals are denominated in US dollars, and that represents another topic of difficulty for EU banks, contributing to the demand for risk transfer,” said Castellano.

While the use of insurance for capital relief has become more widespread, it varies from one bank to another, Sturani noted. “Every banking institution has a different lens and a different view on how they use credit insurance products. And how they achieve capital relief depends on their internal risk modelling. Basel III is principles driven, which means a degree of interpretation,” said Sturani.

The underlying risks also vary greatly: one transaction could be funding a refinery project; another might be mortgage credit; football clubs can even use such asset-based financing to accelerate transfer fees typically structured over several years. “Football finance has been a big area for us over the past couple of years,” said Aaron Bailey, client manager for structured and capital solutions at Aon.

Castellano described another application for credit risk transfer through insurance. “We worked with an important producer of mineral water in Italy, which had been using letters of credit,” he said. The cost of this was significant to the buyer. By putting together a credit insurance scheme similar to a letter of credit, we created more capacity to the buyer for a lower cost, while the seller was able to offer a better price.” continued Castellano.

Acquisitions finance represents a major opportunity, particularly for payment obligations deferred and amortized over several years. A company might not be comfortable taking on the counter-party risk of the firm buying its business, where a proportion of the purchase consideration is extended for a number of years. 

Stuart Lawson, CEO EMEA of Aon’s international credit business, said: “In these cases, we have successfully used the credit insurance and surety market to protect the seller if the buyer defaults on a future payment. This credit enhancement also allows the transaction to be far more attractive to banks to finance.

“With products before, we’ve seen insurers reluctant to change. Now with what Zurich is doing, we’re seeing a willingness to adapt, demonstrating creativity to insure such projects,” Lawson added.