As the credit risk market, which was severely impacted by the 2008 credit crunch, faces up to another crisis, Berta Cunha, MDS Group advisor on credit insurance talks to Nick Hedley, head of political risk and trade credit, Ascent Underwriting, about the state of the market, the outlook for the future and the impact of the coronavirus pandemic.
Berta’s opening question is on the ongoing pandemic and lockdown measures and how these are affecting different economies, world trade, economic growth, and the development of new projects, and, of course, what impact the pandemic is having on the credit and political risk market. Nick’s response is perhaps unexpected, as he states that in the “medium to long term, it will have very little effect.”
However, there are, he adds, some obvious short-term challenges. “If we look back over the last 40 years, we see that every ten years the market faces some serious threat to its existence. The market has successfully traded through these challenges, and come out the other side stronger than it went in. At the start of the 1980s, we had the first debt crisis when Mexico defaulted on its debt and caused mayhem in the sovereign credit market. There were also very severe recessions in many European countries, including the UK.
“Fast forward ten years, to the 1990s, and there was the breakup of the Soviet Union, the start of the Yugoslavian civil war, the Iraqi invasion of Kuwait, and in the UK a fairly deep credit recession. If you then jump forward another ten years to the turn of the millennium you get the Asian crisis, Russian devaluation, quickly followed by 9/11 in the US, all of which had pretty serious consequences for the market.”
We are talking history; you always have to look to the past to fully comprehend the present. Nick continues. “Ten years later, give or take 18 months, we had the financial crisis; and now, forward another ten years and we have the Covid-19 crisis. So, every ten years our market experiences, generally, a cluster of unrelated events, which together have the potential to be very serious. However, the present crisis, Covid-19, is really just one event as we haven’t so far seen any other political events.”
Focusing on the credit insurance market, Nick again looks to the lessons of the past: “Looking back over the last four decades, I would say that in each of those crises, the credit and the risk market performed pretty well. Claims were paid. And as a result of the lessons learned, the products evolved slightly, and new types of coverage appeared.”
Covid-19 reaction – the role of government
Returning to the present day, Nick reflects on the action taken by governments. “I think that in terms of the Covid-19 crisis, we are benefiting from some very useful lessons that were learnt in 2008 and 2009. The failure of governments at that time to put together a valuable, workable credit insurance backstop led to credit insurers cancelling cover and not supporting clients. I think the situation in 2020 has been completely different. I was initially very sceptical that the UK government’s credit reinsurance backstop would actually do anything. I was completely wrong. It has prevented insurers from cutting credit limits, it has ensured the continuity of cover, and all the insurers I have spoken to say it has made a huge difference. I believe the same is generally true across the European Union, as well.
“So, what does this mean for the market? I would say that in the immediate short term, the credit insurance market has benefitted from the backstop that has been made available by the authorities. Governments have also benefitted because we have not seen the wave of insolvencies that we probably expected to see. And that has been largely due to government support schemes, generous lending, access to finance, furlough schemes, etc., which have prevented companies failing that would otherwise have gone under. So, in the immediate short term, it has been quite benign. I think that much will depend on how governments manage the removal of the backstops and the generous lending facilities. That is going to be the challenge. When those come to an end, what’s that going to mean?”
Berta asks if Nick thinks there is a risk that these temporary stimuli will become permanent or lead to an increased role for government, with export credit agencies being more active and influential. Yes, it is a risk says Nick., “I say risk because that would be unhelpful in the longer term. I don’t think we want governments to be interfering too much in the credit insurance market, the political insurance market, particularly not in short-term conventional trade credit. I think there is a danger it could become more permanent, because it’s going to be difficult to wean the credit insurers off the support in an orderly manner.”
Sovereign credit risk
The conversation moves on to the issue of sovereign credit risk. “We’ve spoken so far about the corporate, commercial sector. I think the danger is that when you are looking at sovereign credit risk, the danger is potentially even more acute. A lot of Sub-Saharan African countries are heavily dependent on oil prices. If the oil price remains heavily depressed because of Covid-19, it is questionable whether many of them will be able to pay their sovereign debt. The fact is that all of the loan agreements for infrastructure projects, financed via credits between governments, multinationals, and banks, have cross-default clauses, which means that if the respective Ministry of Finance defaults to one particular bank, it is simultaneously deemed to be in default to every other loan it has taken out. All of which means that you have a potentially systemic crisis. If for example Country A defaults for these reasons, there is a chance that Country B, Country C and Country D will as well.”
Returning to the original question on the impact of Covid-19, Nick comments: “In the short term and in the trade credit insurance market, it’s probably going to be fairly benign. We have got the support of governments and that support is probably not going to be withdrawn in an arbitrary or too aggressive manner. Hopefully, it will continue, and be gradually taken away in an orderly manner as the situation recovers. But if you then look at sovereign credit risks, the “Contract Frustration” class as we call it in our market, I think the potential is much greater. You have the potential for these cross-default clauses to be evoked and contagion across other countries with a similar GDP and export base. To stop that from becoming a catastrophe we would need a package of measures and support from international institutions and credit agencies which would look very similar to the support that EU governments have given to short-term credit insurers.
“If for instance, the multinationals, the African Development Bank, the World Bank, and the Asian Development Bank, provide relief support to sovereign credit, a severe problem could be avoided. However, I fear that is where the danger of something’ going badly wrong for our market lies, and it could go badly wrong. I think the short-term traditional multi-buyer trade credit problem has a much shorter-term horizon in terms of how the problem rolls out. . The support being provided by governments is clearly working. It is the potential for a real crisis in the sovereign credit area that worries me more. Is it likely to happen? Probably not, hopefully a vaccine will be developed, and African countries do seem to be more resilient to the pandemic than some Western countries. So, I think it is a low probability, but if the problem were to arise it would certainly be highly severe.”
What is the situation, asks Berta, for developments in Latin America compared to African countries? The same rationale will apply to any country that has a fragile economic base, responds Nick, although he adds: “Latin America has made great progress in the last 20 years in terms of creating a wealthy middle class. Africa, is not there yet, I think it is 20 years behind Latin America. Therefore, I think the potential for political instability, regime change, and coup d’états are much more worrying there than in Asia, or Latin America. We have already seen, for instance, in Ethiopia, a significant deterioration in political stability, and we are watching what is going on in the Ivory Coast. Africa is poorer and does not have an established middle class, because prosperity is much more thinly spread over the population. I think the danger there is that there isn’t the social infrastructure to cope with a big reduction in GDP or in export earnings, and that’s why you have this potential for instability.”
New opportunities for credit insurers
At a moment in time when we are facing the restructuring of global supply chains, and an increase in digitalisation across our personal and professional lives, Berta says she believes new opportunities for credit insurers may arise. She asks Nick for his views on the possible emergence of different risk profiles and changing client needs that may require new solutions, and what the innovation trends in the credit insurance market are.
There has been a lot of innovation in the credit insurance market over the last 20 years agrees Nick however he says that he struggles to see what else can be done over the next ten years. “If we look back over the last ten, 15, 20 years, the credit insurance market has become quite heavily digitalised. Most underwriters have facilities for clients applying for cover online and provide instant answers, and you do not need to do it in the old-fashioned way. I imagine the credit insurance market will continue to evolve. I think bigger ticket business – export finance and political risk business – is still quite an inefficient market, unlike the credit insurance market. Risks still tend to be placed, you know, using pen and ink, and stamps. I think and hope that is where we might see innovation in the next five years and try to make that an easier line of business to handle.”
Sustainability is the word
To recover economic resilience, Berta stresses that countries will have to embrace structural reforms, such as target investments, sustainable infrastructures, and the transition to a low-carbon economy. Does Nick anticipate that the credit and political risk markets will also have to follow this path?
Yes, responds Nick, an increase in demand for renewable, sustainable business can be expected. “We’re certainly seeing, and I’d say this is particularly true in political risk insurance, a big increase in renewable energy-type projects, and we’re seeing a lot of support for that.” However, he adds: “We still see enquiries, regularly, for coal mines and traditional carbon-intensive industries. Even if, more and more, we find that these risks are harder and harder to place. That said, we are certainly seeing a trend; the market is interested in renewable energies, sustainable business, etc., and that is where the capacity is now going, whereas a traditional US energy firm or coal mine or similar, will be struggling to find support. It’s still available but proving more difficult, and I think that’s going to become increasingly more difficult as we go on,” he concludes.
“As for environment and sustainability being criteria to access this kind of coverage in the future, export credit agencies already have some rules regarding this, and the private market is also following this approach, because governments are more and more of a mind that investments should be linked to the impact they have on the environment and sustainability,” he says. “However, as I see it, the private market will always be more flexible than the Export Credit Agencies (ECAs) in terms of continuing to support old-fashioned investments in ‘dirty energies. That is a much longer-term solution, so the private market is prepared to support that, but I don’t think the ECAs or the multinationals would have done that because it would have breached the ‘we don’t do coal’ rule. So, I think the private market will always be more flexible than the State sector.”
What about SMEs?
Political risk covers are mostly bought by large corporates, but can SME’s look forward to having the same kind of support for their investments or exports to risky countries? That, says Nick, is an interesting question, “because the product we have developed at Ascent is specifically targeted at smaller companies. It is a product that will provide not just political risk insurance to indemnify the insured, in the event they lose their investment; equally importantly, it comes with a support package provided by a crisis management response company, which will work with the insured in a crisis situation to try and alleviate the effect of the crisis. If it is a political crisis, they will help the insured negotiate with the government; if it is a physical security-type crisis, they will advise the insured on how best to preserve the safety of their employees; and if one of their staff has been seized by the government or rebels, they will help negotiate the release.
“So,” he adds, “we have a real interest in working with smaller companies to provide them with political risk protection, which includes not just paying out in the event they lose their investment, but more importantly, providing them with the tools they need to either manage the problem or mitigate it, and avoid a total loss. There are a number of other underwriters in the political risk market who share that same view. It allows you to get to know the client very well and having the crisis management support provided alongside the insurance goes some way to mitigating any insurer fears that smaller clients will not be able to manage a deteriorating political situation, compared to a larger company with an established crisis management procedure.
“As I say, I think there is a general recognition that if you’re working with smaller companies, providing the crisis management response tool, alongside the indemnity tool, goes a long way to mitigating that problem.”
And we are not just talking about the larger SMEs but the really small ones. “The smallest insured that we have taken on this year had an annual revenue of around £5m. They have proprietary technology, which is employed to clean up wastewater from hydrocarbon facilities. They recently attracted a substantial new shareholder, so while the revenue, historically, has been very small, they now have more substantial resources. And whilst they have one particular project in the Middle East, the project that we insured, they now have other contracts with other Middle Eastern oil producers, for an identical type of water treatment plant. That company will grow rapidly, so the existence of political risk insurance was critical, for them to be able to proceed with that first investment. We are presently looking at a similar size company for a telecoms risk.”
Hoping for the best, preparing for the worst
As the conversation comes to an end, Berta asks if there are any further insights Nick would like to share with FULLCOVER’s readers. As a final reflection, he says – while acknowledging that it is a bit of a cliché – “we should expect the unexpected; I mean, nobody foresaw Covid-19. And on the political side, I can see that there are many areas of potential danger at the moment – China and Taiwan could for example be a problem. China is becoming increasingly more assertive.
“All the problems I mentioned at the start of this conversation, covering the last 40 years, not one of them were forecast. I think that simple fact reinforces the need for both credit insurance and political risk insurance. It should force a reassessment of clients who do not currently buy this insurance, as to whether that is the appropriate thing to do.
“I take the view that the cover has never been more important. I think the way it has performed during 2020 with Covid-19 is another powerful argument as to why it’s a good product that performs well and does provide real benefits, real assistance, and real protection in the event things go badly wrong.”
Well, we all hope they don’t go wrong. Still, hope for the best and prepare for the worst – although had we followed this principle then maybe 2020 would be remembered differently by history.