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Ep350: How Lenders Manage Credit Risk with Insurance
00:25:33
Ben Roberts, president of Texel Group, discusses how non‑payment insurance works in project finance and how lenders use it to manage credit risk, allocate capital and support lending activity.
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Transcript34 lines
- [00:00]
A
Foreign.
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B
Welcome to Currents and Norton Rose Fulbright podcast. Today we're recording with Ben Roberts, who leads a team at Texel's Group. Texel Group's a credit insurance broker that provides default risk for primarily for lenders. And they focus. Ben at least has a focus on Project Finance, so that's why we asked him on today. And credit risk is one of the primary means that Project Finance lenders use to mitigate their own risk and keep our markets liquid. So Ben, thanks for recording with us today.
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A
No, thanks, Todd. Very, very happy to be here. Thanks for having us.
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B
All right, so I think, I know I called it credit insurance, but I think probably the technical name is non payment insurance, which I put on my lawyer hat instead of my podcast host hat. But I should call it non payment insurance. But people in the audience may have heard it referred to either way, what is it and how does it differ from a credit default swap, which people who are not in the lending community are more likely to have heard of?
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A
Yeah, no, it's a very good question. And I think the, to get to it, I mean, non payment insurance is also called credit insurance. There's a lot of interchangeable use of that phrase or those two phrases. I think there is a move towards using non payment insurance as the product that is used by banks to cover default by borrowers under various different asset classes, including project Finance. Credit insurance perhaps brings up a little bit more familiarity with trade credit insurance so corporate covering its receivable exposure when it's selling on payment terms to a buyer in whichever industry. But non payment insurance is probably the term that's more regularly used now when referring to banks who get coverage against default by a borrower under different asset classes.
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B
The way I think of it, not never actually having procured it inside a bank is a bank lends $100 to the borrower and the bank wants to show the regulator that some of the risk is gone. They got two ways they could, well, I guess they got three ways they could participate the loan too, that you could assign the loan, you could participate the loan or you could find somebody like you who could do some underwriting on it and then insure the risk and then the bank's really taking your credit as opposed to the borrower's credit.
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A
Yeah. So I mean, firstly the textile group is a broker, an insurance broker. So we sit in between the bank as the insured and the insurance companies who are ultimately the ones that taking on the risk and have the A plus, double A minus credit rating that the bank is Then looking towards. So our role is working with the banks, the financial institutions who are our clients. They will come to us and they will say we want to lend, as you say, $100 for this renewable energy project in the US or in emerging market or whichever country. And we want to manage our exposure on that. So we will still front 100 million, but perhaps we actually want to get insurance for 50 million for half of that participation that we're on for this facility. We would then approach the insurance market. Insurers, there's probably 60 or so insurers globally who are providing non payment insurance coverage. As I say, ratings tend to be between A plus AA minus, probably AA minus on the average. And we will look for capacity participations on an unfunded and silent basis from those insurance companies to support the bank. So when the bank is actually executing the transaction and lending the 100 billion for the project, they will in the background have 50 million of insurance coverage that would respond in the event that the borrower, the project defaults under the terms of the loan agreement. And actually the product itself works very simply in that it's non payment for any reason and it's non payment on a due date under the loan agreement. So when that happens, the loss definition under the policy is triggered and then after a waiting period the insurance companies will pay out the claim for 50% of whatever the actual dollar amount of the loss is.
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B
And then do they get subrogated to the rights of bank and then you wind up, or the lender, whoever they're insuring, and then you wind up that there's a whole claims process for that or how do they coordinate going forward? Because if they pay out and the borrower presumably hasn't paid, there has to be some reckoning at some point.
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A
Yeah, so as you say, the insurance companies will have, once they pay the claim, subrogated rights to portion of the recoveries on that transaction on the loan itself. So typically there's a period of time between the loss occurring and the insurance company paying out. So actually there may be a period of time where a transaction is being restructured and actually maybe the loss is reduced or even completely restructured at that point, in which case insurance companies do pay, sorry, don't pay. In the event that they do pay, then any recoveries that the bank is getting in relation to that transaction that the insurance companies are getting 50% or the agreed portion of those recoveries. I think it's important to say that the bank is usually one that is negotiating with the borrower on behalf of the insurance companies. So the insurance companies who initially are providing that unfunded support are in the background whilst the policy is live. If there's a loss and they pay a claim, typically they still sit within the background. Maybe they're coordinating with the lenders around the restructuring so that they're asking the lender some questions. But the insurance companies themselves are managers of portfolios of risk across geographies, across assets industries and they are relying on the bank to I guess manage that process in terms of recoveries in which they will obviously share a proportional.
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B
So I assume then that alignment of interest there for the insurer is extremely important because they want to make sure that since they're silent in the background or largely silent in the background, that there's a strong alignment. So what if that is the case? I guess you can confirm that first. But if it is the case, what type of limitations would they put on the lender of record in terms of its ability to trade out of its position?
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A
Yeah, I guess this goes a little bit to what do insurers want to see when they're supporting lenders and project finance? All different asset classes. There's an alignment of interest in terms of a risk share. So the example we Talked about was a 5050 risk share between the bank and the insurance company in the transaction. But really the insurers are looking for to work with banks who they see as partners, so are being transparent with them in terms of the information that they're sharing, are sharing perhaps a spread of transactions over a period of time. So the insurers are seeing maybe some of the tougher credits, lower rated credits on the book, but also maybe some of the better credits as well. And then really that transparency and information sharing hopefully allows insurers to get very comfortable working with the bank so that when something perhaps does go wrong or there's a restructuring needed on a transaction, that the insurance companies are happy that the bank is going to do what's needed in its interest and also the insurance company's interest. So yeah, I think that partnership approach is something insurers really like to see and ultimately enables them to support a really wide range of transactions for banks who are using the product is there
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B
because of that need for an alignment of interests. A generally accepted. I'm sure there's always exceptions to everything but accepted practice in terms of what percentage of the credit the insurer will be willing to insure. So an example we gave was 50 50, but could you insure 90% of
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A
the credit in circumstances, yes. I think it when we're talking about Project Finance and I think it's an area where insurers five to 10 years ago maybe had less exposure, less familiarity, there was perhaps more limitations in the level of insurance you could get as a bank on an asset. Over time, as insurers have grown their book of business with banks on Project Finance and a very kind of broad range of different Project Finance asset classes, they've got more comfortable with specific banks, they've got more comfortable with different Project Finance assets. And so the level of insurance that banks can now get that has increased. I think when you get towards 90%, you get really towards the limit of what insurers may agree. But it's also determined by the market. So the availability of COVID for a specific transaction, if there's lots of capacity available from insurers and the bank is only looking for a small amount of COVID then there's room to negotiate with some insurers and perhaps get that higher level of COVID that the bank might be seeking. So I guess it's very dynamic and nuanced depending on the asset class, depending on the specific transaction that we're talking about. But in certain cases, yes, you can push towards that higher level of COVID And there's various reasons the bank might obviously want to achieve that in Project
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B
Finance market generally, what types of debt providers are using this credit insurance? Is it more heavily used by commercial banks, used also by credit funds? Is it used by the life insurance companies? Who's the target audience here?
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I mean, the largest uses probably European and Asian banks, and that's in the US and probably globally. And the reason for that is that they're able to get the capital relief benefit of using insurance more so than US Lenders who perhaps find it kind of difficult. So for European or Japanese banks and also other institutions, Australian banks, Canadian banks as well, they're able to substitute rating of the underlying project for the rating of the insurance company. As long as the insurance policy qualifies as an eligible guarantee, the bank is able to substantially reduce the amount of capital it has to hold against the insured transaction. Freeing up capital obviously means more lending, the ability to grow portfolios of Project Finance books for the bank. So for that reason the those institutions are probably the largest users of the product. Obviously banks are using it for credit limit management as well. So being able to expand holds or participations on certain transactions, get to higher tiers of lending on transactions, manage exposure to clients, because if they know there's a pipeline of transactions with a certain Client offsetting some of the risk and having that recognized internally allows banks to do that. So commercial investment banks are by far the largest users. Credit funds or maybe life insurance companies, I would say are much more limited at this point. There's certainly some who have perhaps have a focus on infrastructure or project finance debt, but the reality is I think it's a much more limited use of the product by those entities. So commercial investment bank is very much the core market who use the product at scale.
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And what about the asset themselves? Is there preference for renewables over whatever, you know, gas fired power plants or data centers or. It really doesn't make much difference to the insurer. As long as they can understand the business model, they can insure pretty much anything.
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Yeah, I mean, I'd say that from a broker's point of view, we always take the optimistic view that if the bank is financing a transaction, then it makes sense and we have to then convince the insurers that it also makes sense. So we're always optimistic that if there's a rationale for the bank to be doing it, we can hopefully find some insurance support. There's always a trend that the request, wherever the bank market is, whatever they're focused on in a particular year or over a periodic period of time, the insurance market is also inevitably going to see those types of transactions or those types of assets. So as you can imagine at the moment, the large scale LNG financings are a very active area. Which insurance market is supporting lenders, Data centers. Of course, for the same reason, given the scale and the number of those transactions that are in the market, the insurers are getting a large number of requests to provide support for those as well. Renewables. Over I guess the last five to 10 years, and particularly in the U.S. there's been a large amount that has been done, I guess in the last year or so, there's perhaps been a little bit of a tapering off of support available to banks looking to cover their renewable exposure. But on the other side, if there is a renewable energy transaction, solar, wind transactions, battery storage, that banks are looking to still finance, then there's a rationale and any of the regulatory hurdles or concerns that the insurers might have, the bank will no doubt have addressed and therefore we can still, I think, make a strong case to the insurers to try and find coverage for those assets. So very much the insurers, I suppose are jacks of all trades to a degree. They follow what the banks are looking for them to do and have a A large amount of flexibility in what they can do. They're always willing to learn and to listen if it's a new asset class that a bank is looking to finance and needs insurance support on as part of its distribution or capital management tools. So, yeah, very, very much open to a wide range of assets.
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What's the cost of insuring debt? Obviously I shouldn't say obviously because I don't know. I'm assuming that it has to do with the kind of worthiness of the loan itself. Maybe you could kind of make a correlation. So to get give a, give a framework, I'm assuming it's.
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There's a range very much. The insurance companies will look at the underlying spread on the transaction to benchmark where their, their premium rate is going to be. So typically the, the spread above the base rate will be what the insurers are looking at and they, I guess, will have a range and it's between probably 50 to 70% of that spread. That is the cost of the insurance for the 50% or 90% of the loan that is being covered by insurance. So really that is typically where insurers are coming in at somewhere in that range. And again, it depends on the asset class, the specific transaction, how much demand there is for insurance coverage from different lenders on that deal. So supply and demand does come into it, but that's typically the range. And insurance companies don't earn or share in any of the fees that are earned by the bank. So underwriting MLA or JLA fees that the bank may earn are not shared with the insurers. So it's purely benchmarked against the spread and therefore the earnings that the bank is making on the debt itself.
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So if I'm understanding it right, if I had, going back to my simple example, if I had $100 million deal, I don't have to share any of my upfront fee with the insurer and I get to keep somewhere between 25% and 50% of the margin on the deal.
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For the insured piece?
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Yeah, for the insured piece. So again, in the 50, 50 example, I get 100% of the margin on my 50 and I get 25 to 50% of my margin on the other 50. Why wouldn't to me looking at that math, assuming the market was liquid enough, if I was a bank, I would do that all day long.
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A
And to your point, I mean, certain lenders, I guess, have adopted insurance as a product that they're using on a very regular basis and it sits perhaps sometimes alongside other distribution mechanisms. So true sale of the loan or funded sales of the loan are often used in a kind of complementary way to the insurance market. And perhaps the banks who are most active and most successful in using the insurance market see it almost alongside sale of the loan as a way of managing its exposure and managing its risk. Obviously it's an unfunded product, so sometimes funded sales are preferred by the banks. But there was some good research done by the International association of Credit Portfolio Managers which looked at the different distribution or risk mitigation methods used by banks. And certainly in EMEA or APAC lenders insurance was either the top or the second preferred distribution risk mitigation method for US Financial institutions. It's a little bit further down the list and I think that's because it doesn't yet easily have that capital management benefit that it does for other lenders.
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How about in terms of structuring? To what extent does the insurer get involved in the structure or does the, the insurer basically take, take it as it, as it's served up to it and then prices accordingly?
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Yeah, the latter. So really the insurance companies are not involved in the structuring upfront of a deal. And, and kind of to the point we talked about earlier, they're not also involved if something is going wrong other than having information provided to them, asking questions. So they're not actually involved in pushing certain strategies. They're very much looking to the bank to say this is what we think is the right approach here. But yes, upfront, at the start of a transaction, the insurance companies are approached with an info memo, a term sheet, a financial model, and they may have questions around that that they are looking for the bank to answer. They may even join a call with the bank who will take them through the transaction. But they're not suggesting changes to the structure in any way. They're looking for the bank to say, this is the deal, can you support it? And we'll do our best to get that insurance support for the bank.
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B
And what's the timing for execution? Again? You know, in a, let's say a standard deal, I'm sure there's ones that have taken months or maybe even years. But you know, not, not taking a worst case scenario and not taking an absolute best case where you're at, you know, December 10th and somebody says this has to be done before Christmas, you know, well, if somebody's planning to go do this, but on a, on a good pace, where they care and they want it done, but not, hey, look, everyone's going to work 24 hours a day to get this done. What's the timing look like?
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I mean, it is really determined by the lender. So the banks are the clients of the insurance companies. There are clients as well. And so if a bank turns around to us and says we need to have cover in place on this next week because we need to meet a deadline set internally for whatever reason, then we need to get the insurance companies and we need to meet that deadline. Otherwise actually really the process follows the timeline of the deal. So often we're approached at term sheet stage and then we are working with the bank and working with the insurers to make sure that when the deal is closing that the insurance policy is in place and bound for the financial institution. There are times, and it's relatively common actually for the deal to have already closed and then the insurance to be placed because the insurance is perhaps part of the syndication or distribution strategy. And so exactly where the funded sale capacity is going to come in and the insurance is going to come in is maybe not known even at the point that the transaction closes. However, we're likely to have an understanding of what might be needed at that point. So the timing is really driven by whatever the bank needs and that can be very short term or it can be evolving over time.
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As a dealer, you kind of answered this question I think already, but for let's say a slightly different technology risk. So let's say you were looking at a long duration energy storage project or some type of hydrogen project or what, you know, whatever it is something that is not run of the mill, that there haven't been 20 of them financed already. Is it still a simple, simple. So let's say Instead of at SOFR +175, that deal is going at SOFR +400 or something. Is that is kind of the ability to insure a deal like that similar to what you discussed before? Or is that really become there's a much smaller group of potential insurers who you could go out to for bids and you may not be able to get insurance for that. Or if you do, it's going to be extremely costly because there's not a deep market for that or is it really not that refined? What market?
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I mean, it's a great question. I think there's so many moving parts perhaps to consider around, around that example. So is the bank a regular user of insurance? Have they got a relationship with the insurance market? If the answer is yes, then actually they're going to have a very good ability to present their case to the insurers, meetings, calls to explain, you know, what is this specific transaction? What is, I guess, any underlying novelty around the technology or the industry that the bank is looking to finance that they need the insurance support on? Is it a different geography? Is it the US or is it emerging market? And actually insurers can get very comfortable even in emerging markets for sort of new technologies or new types of project finance as well as obviously in the US as well. So that's kind of one area, kind of what is that existing relationship with the insurance market? Obviously there's gotta be some form of understanding around the technology itself. So that teaching or that information sharing is going to be really, really helpful. I think partly our job as the broker is to make sure there's enough or as many insurance companies as possible to listen to that story. The pricing that the insurers will charge from a range point of view is unlikely to differ too much from what I was describing. And actually if we can get the insurance comfortable with the asset itself, the credit profile of the asset that's being financed, then I wouldn't see that the pricing would change too much beyond that range. It's likely still to be within that area, but very much where it's a new asset. Underlying technology, it's is really about providing that transparency and bringing the insurers in to ensure they understand it. And why is the bank looking to do this deal and why does it need the support?
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B
So let's end on that note. If somebody's out there in the bank market or other debt providers looking for this type of insurance, what's the appropriate time to approach somebody like you about the deal and what do they need to do to actually procure the insurance?
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A
I mean, at this point in time there's a lot of demand. As I think I mentioned, there's some certain asset classes in project finance, lng, renewable projects, as well as the data centers. And so in approaching the insurance market for perhaps those specific asset classes as early as possible is definitely the advice. And that's very much before the transaction has concluded. So kind of at the term sheet memo stage when the deal is still being thought about, I think there's always a possibility to find cover after a deal is closed because it may be getting insurance as part of portfolio management or because there's a pipeline of transactions that the bank wants to enter into that by managing its exposure using insurance actually on existing deals, it can free up capacity for new transactions. In terms of approaching us, I mean, we textel is. I'm based in New York. I run the Americas business. We have our headquarters in London and offices in Asia as well, really spanning the geographies that our clients are based in. And we're obviously happy to speak at any point in time, but we're always very much engaging in discussions with banks who are considering or not considering insurance in various different ways. So always happy to chat.
- [24:56]
B
All right, well, I'm happy you chatted with us today, and thanks for your time.
- [25:01]
A
Thanks very much, Todd.
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B
You can find us online at www.projectfinance.law or send us an email at currentsortonrosefulbright.com Please rate, review and subscribe on Apple Podcasts, Spotify, or your preferred podcast app. Our show today was produced by Emily Rogers. Stay ahead of the Currents.