Shop talk: Lloyd’s rule change a boost to credit insurance buyers

Credit insurance has been a cornerstone of trade and trade finance for more than 100 years. For the last 30, Lloyd’s underwriters have played a key role in supporting corporates, traders, and banks in their trading all over the world. A committee of the Lloyd’s Market Association (LMA) has worked closely with the Corporation of Lloyd’s (which runs the market) to modernise the way credit insurance is underwritten there. The changes deliver many benefits to buyers.

Credit insurance covers an insured against default by a counterparty to whom they have extended credit. This could protect, for example, a trader selling a cargo of sugar to a refinery in Poland, a corporate selling medical equipment to a newly constructed hospital in Ghana, or a bank undertaking secured financing of oil and gas assets in the Permian Basin. 

Until recently Lloyd’s regulation of credit insurance comprised a prescriptive set of technical rules. This list of do’s and don’ts for underwriters was updated following the financial crisis of 2008. The rules made sense at a time when the whole financial sector was looking at its approach to credit risk, and trying to ensure balance sheets were as safe as possible.

The regulations restricted Lloyd’s credit insurance underwriters to risks with either a direct link to a specific trade or where security over an asset was in place. The thinking was that the theoretical self-liquidating nature of a trade transaction and the ability to take security would make these policies more secure.

Unintended consequences

These rules, well-intentioned as they were, often had the opposite effect. Trade-related structures and security are often required for counterparties that are not very creditworthy, so underwriters often took risks on credits that were not strong enough. Claims ensued, producing the opposite outcome to that intended by regulators. Lloyd’s underwriters had also become more sophisticated over the past 10 years, employing credit analysts and data suites to better-quantify credit risk, thereby supplementing and improving their risk selection and underwriting.

Another market development further highlighted the issue. In recent years, driven by the implementation of Basel III-compliant policy wordings, banks have been able to use credit insurance for capital relief, as well as for risk transfer. This suddenly allowed banks’ portfolios of good-quality credit, such as investment-grade term loans, to benefit from credit insurance. However, Lloyd’s own rules prevented its insurers from underwriting these good risks. Lloyd’s was shut out, while other insurers were able to take advantage of this high-quality business.

A clear opportunity had emerged to press for a different approach to credit insurance at Lloyd’s. The LMA created a working group of leading underwriters which successfully changed, for the better, the way Lloyd’s regulates credit insurance. From 1 January 2019, Lloyd’s has abandoned its prescriptive set of technical rules in favour of a risk-based, proportionate regulatory framework.

The requirement that credit risks had to be trade-related or secured has been removed, and a small increase in market capacity — a proxy for the amount of risk Lloyd’s can underwrite —  was approved. The change puts underwriters in the driving seat. As long as they have the tools, capacity, and ability, Lloyd’s will allow them to underwrite what they choose.

This new approach has benefits for clients and their insurance brokers. It allows Lloyd’s underwriters to get back to what they do best: writing complex risks to benefit clients. A broker now has to worry only about convincing them it’s a risk worth taking, not that it’s a risk they’re allowed to take.

Not all credit risks can be underwritten at Lloyd’s, but brokers and customers should see immediate benefits to their business through the market’s changed risk appetite and responsiveness. Some underwriters have already seen new asset-backed lending structures come to the market as potential insureds. This good-quality risk might take more effort to understand and underwrite, but ultimately that’s what Lloyd’s does.