By Jonny Carruthers, Assistant Director, BPL Global
Global trade is speeding up, with trade flows tipped to hit a record US$24 trillion by 2026. The provision of its fuel—that is, trade finance—must keep up. As a result, interest in purchasing pools of receivables to grow trade-finance portfolios is on a significant uptick.
But, of course, this has its drawbacks for the financier—namely in the form of less visibility and control for the bank and, therefore, increased risk. Regulatory pressures and internal risk appetite may also restrict such lending, even to core clients. Clearly, if they are to actively support their clients’ business and foster growth within their trade-finance portfolios, banks must first search for an effective tool to allow them to manage down their residual risk to palatable levels.
This is where XoL (Excess of Loss) credit insurance comes in. Recent product and technological developments, coupled with new underwriter entrants, now mean that XoL credit insurers can provide up to 100 percent cover for banks purchasing pools of receivables, while also enabling them to achieve regulatory capital relief under Basel III.
XoL under the spotlight
At its core, XoL credit insurance is specifically structured to cover against catastrophic losses. It is not a new concept: major corporates and commodity traders have a long history of using the tool to mitigate against unexpected losses, and to facilitate more business.
The private insurance market has more recently seen rising interest from banks in XoL-structured policies to insure large pools of receivables—often entire portfolios—against trade credit risks, such as a default caused by insolvency, protracted default and political risks.
How do they operate? Picture the XoL structure as a jar: eligible losses are incrementally added to the jar and accumulate within it until it is filled to the top—which signifies that the aggregate first loss threshold as defined in the policy has been reached. The next drop into the jar over this threshold—the excess of loss—triggers a claim for insurers, allowing the insured party to claim under the policy for any aggregated losses breaching this deductible.
Of course, this means the insured party must be of a suitable size to be capable of absorbing the initial losses. That’s why XoL credit insurance lends itself best to those institutions with healthy balance sheets and robust credit-management processes—such as large international banks and the corporates that they finance. The stability offered by a defined deductible figure replacing a general bad-debt reserve is also appealing to many companies.
Quality credit management is especially important to meet the selection criteria of many XoL credit-insurance carriers. When looking at a portfolio, the insurers, the broker and the insured party work together to cherry-pick the receivables that perform on a regular basis for coverage. This is vital: the intention, of course, is to not have losses.
Purchase motivations for banks
The value of XoL credit insurance when insuring large pools of receivables does not end at straightforward risk mitigation, however.
Firstly, XoL credit insurance represents a strong alternative to banks having to rely on their client’s own insurance, and therefore, being in a less secure loss-payee position. Why? Because if a bank becomes the insured party, it then will be responsible for fulfilling the policy’s reporting requirements, thus giving it control over the associated operational risks.
Moreover, by becoming the insured party, banks can potentially appreciate a secondary benefit: capital relief. Under Basel III regulations, credit insurance can be applied by banks and interpreted for capital relief. Of course, this is subject to jurisdictional interpretation and legal opinion—but it is certainly a practice that is widespread and appreciated among many banks across Europe and Asia.
Thirdly, it serves to improve their advance rate. By offsetting their own risk through XoL credit insurance—and with scope to do so by up to 100 percent—banks can better manage internal risk limits and increase lending.
Moreover, simply having the insurance itself can be a crucial draw for secondary investors in such portfolios, should the financier originate and distribute via securitization. From that perspective, securing cover for the senior quota from an investment-grade insurer can speak volumes for the strength and quality of the underlying transactions.
A further notable benefit is the flexibility of structure: the revolving policy period allows for short-term receivables to be added as new invoices are generated, and payments received—assuming they are eligible under the pre-agreed selection criteria. Indeed, it is rare for just a fixed number of invoices to be covered throughout the policy tenor.
Similarly, the particulars of an XoL credit-insurance policy can be tailored to the specific trade activity that the bank is financing. In the case of agricultural receivables, for instance, a longer waiting period can be built into the structure to align with the seasonality of crops or to mitigate the risk of no or low crop yield for that year. Certainly, this kind of flexibility adds to the policy’s effectiveness to target and mitigate sector-specific risks.
A budding market
It is for these reasons that the XoL credit-insurance market for trade finance is advancing. Indeed, since BPL Global helped place the first-ever XoL credit-insurance structure with 100 percent cover for a bank in 2007, several major insurers have entered the market.
As it currently stands, XoL credit-insurance market capacity could be well over US$500 million depending on the transaction, with policy tenors stretching up to five years (although revolving policy periods would remain at 12 months as standard). While it’s true that the market for trade-finance portfolio insurance is relatively new, it is most certainly growing.
As in many areas of finance, digitalisation is providing a boost to this growth. Given that the invoices underlying a bank’s receivables financing can often reach into the hundreds of thousands for certain trade-finance business lines, manually submitting monthly reports to an insurer can be costly and time-consuming. And that’s not to mention the complexities involved in reporting on receivables that operate on a short-tenor, revolving basis.
Digital reporting platforms, however, are starting to be introduced into the market to streamline this process. By using data extraction, these platforms can sort invoice data obtained directly from the corporate by country, risk—or, indeed, any category as determined in the policy—while still providing banks high visibility over their risks.
Whether the data is extracted directly from a sales ledger, or simply uploaded via an online web platform, the clarity afforded makes it possible to go into granular detail to select which receivables can be financed according to pricing, the size of the facility and the insured’s credit-utilisation record.
Also enhancing and spurring the development of XoL credit insurance is the open culture of the bank-broker-insurer dialogue within the market. By nature, insuring trade-finance portfolios using an XoL structure cannot be a standardised process. The number of variables involved—such as the various underlying credit risks and content of a receivables-purchasing contract between a bank and its client—means that each policy must be created bespoke. Consequently, regular communication with all parties is required—and the more this happens, the more experience and expertise the market collectively gains in meeting the needs of its clients.
Although an acutely focused structure supported by a relatively small market, there is little doubt that tapping into XoL credit insurance could solve risk concerns and unlock significant business opportunities for banks operating in the trade-finance space. And given the added value that can be gleaned from both the structure and the marketplace itself, harnessing XoL credit insurance could well be an option to foster portfolio growth for banks—and, ultimately, their clients.
ICC Global Survey 2018, “Global Trade: Securing Future Growth”, p.12.