Basel III – insurance as a risk mitigant?
RPC's banking team recently attended the Loan Market Association's (LMA's) seminar on "Mitigating Risk – Insurance as a Risk Mitigant" which focussed on whether insurance could be used by banks for the purpose of securing capital relief under Basel III.
Basel III is the third version of the set of minimum standards applicable to banks and came into effect in the UK on 1 January 2014. One of the main requirements of Basel III is that a bank must hold a proportion of its capital to reflect its inherent business risks. The level of that capital depends on the nature of the business and the presence of permissible risk mitigation devices (e.g. guarantees, credit derivatives and ... insurance).
Banks are naturally keen to keep the capital figure as low as possible to free up their assets for profitable purposes. With this in mind, companies may either follow the Standardised Approach or adopt their own Internal Ratings Based Approach ("IRB Approach") if approved by their respective regulator. The IRB Approach may provide the company with greater flexibility and result in them having to hold less capital in reserve.
The Basel Committee confirmed in December 2002 that insurance could be used as a qualifying risk mitigant provided that it meets the criteria applicable to guarantees. (These criteria will be familiar to anyone with a passing knowledge of the Solvency II rules applicable to insurers and their use of reinsurance and other risk mitigation techniques).
In particular, this is relevant to credit insurance, of which there are two distinct types: (i) "whole turnover", which protects the insured from customer payment default for all eligible business within an agreed period; and (ii) "single risk" (a.k.a. structured credit insurance), which protects the insured from counterparty payment default on a specific transaction/deal. The latter is more widely written (including by Lloyd's).
The main issue around whether credit insurance can be used as a risk mitigant in this way is the Basel III requirement for unconditionality. This means that the instrument must be irrevocable and within the direct control of the protection purchaser (i.e. the bank/insured). A typical insurance policy will of course have inherently conditional features, such as the duty of disclosure and the operation of warranties, conditions precedent and exclusions. Non–disclosure, for example, may entitle the insurer to avoid the contract.
Credit insurance policies have had to evolve so as to be Basel compliant. Hence "warranties" have been re-classified as "terms" breach of which will give rise only to damages rather than avoidance. Likewise, the inclusion of wording such as "to the best of the insured's knowledge" limits the duty of disclosure. The control of the insurance contract has therefore swung more into the favour of the insured.
Despite this, certain issues remain As above these relate to the absence or loss of control by the bank/insured, but tend to be fact-specific or trickier to deal with. These include:
- Situations where a third party is named as insured on behalf of a group or syndicate of banks/ lenders. Similar issues arise where a bank is involved on a transaction as a sub-participant.
- Provisions that require insurer consent, before the bank/ insured can take certain actions.
- Provisions that require the bank/ insured to pursue remedies against third parties before the insurance cover is triggered.
- Exclusions (particularly where they are mandatory for the insurer, for example nuclear exclusions).
These issues are all surmountable with careful drafting, but this will turn on the particular facts of the case, as well as normal negotiation dynamics. It will also be interesting to see how the Law Commission's proposed amendments to the duty of good faith and duty of disclosure for business insureds will feed into this. On the basis that these reforms are designed to limit the circumstances in which an insurer may avoid a contract, this may serve as a boost to this particular line of business.