The impact of Covid-19 on the credit & political risk market is a question that all of us who work in this area have been pondering in recent weeks, but one which none can predict with any level of confidence. However, as someone who has been involved in this business since 1981, I am perhaps qualified to place Covid-19 in the context of other crises our market has weathered. I can also attempt a prediction of what it is likely to mean – both for those of us who work in the insurance market and for our core clients who are engaged in foreign trade and investment and to whom we owe our livelihood.
First, though, I should clarify which segment of the credit & political risk market I am going to address. This is necessary because there are three distinct markets writing credit & political risk business:
- First, there are the short term Whole Turnover insurers writing on a “whole account” basis. This market is dominated by the likes of Euler Hermes, Atradius and Coface. Estimated premium income $7bn per annum.
- Second, there is the Export Credit Agency (ECA) market, which comprises government agencies writing difficult and large long-term cross border risks on behalf of companies operating in the ECA’s country that can demonstrate that the transaction in question meets national content or national interest criteria. The “underwriter” is the taxpayer, through the national Treasury. In the UK, for example, the ECA is UK Export Finance, in Sweden it is EKN, in Spain it is CESCE and in the US it is Eximbank. Aligned with the ECAs are the multilaterals who are jointly owned by multiple governments, and whose purpose is to support trade and investment within the member states. Afreximbank, Africa Finance Corporation and MIGA are good examples of multilaterals. Estimated premium income, $7bn per annum.
- Third, there is the “Private Market” (“our” market) which comprises approximately fifty insurers writing political risk insurance, contract frustration insurance and structured credit insurance. Unlike the short-term Whole Turnover market, Private Market business tends to be single transactions or investments for large amounts and often for lengthy risk periods. It is essentially the same type of business that is written by the ECA’s and Multilaterals, but for commercial gain and without the national content / national interest eligibility hurdle. As an aside, the Private Market provides significant reinsurance support to the ECA’s and multilaterals. Estimated premium income $3bn per annum.
In the course of this paper, I am only going to consider the implications of Covid-19 for the Private Market.
The historical context. The Private Market evolved from the late 70’s and early 80’s when Lloyd’s (led by Merrett and Hiscox) and AIG started writing Contract Frustration business. Hogg Robinson (through its subsidiary III) under the leadership of Julian Radcliffe was the main sponsor on the broking side. Prior to 1980 some level of CEND business (Confiscation Expropriation Nationalisation Deprivation) had been written but in a very small way, and mainly based on reinsurance of OPIC’s PRI programmes. From 1980 onwards the Private Market started to devise new products (contract frustration for instance) and significantly to grow the premium base, in the course of which an entire industry was formed.
Looking back on nearly 40 years in the business I can detect a pattern in loss activity:
- At the start of every decade (give or take a year or two either side) we get hit by a major event which causes market wide disruption.
- Between the major events (which arrive with uncanny precision at the start of every decade) we experience a number of “local difficulties” that (while painful for certain players) do not cause market-wide disruption.
Covid 19 therefore arrived with uncanny punctuality at the traditional point in the market’s cycle.
The “major events” that arose on or around the start of each of the past four decades were as follows.
- Default by Mexico on its international debt – triggering the International Sovereign Debt Crisis that caused massive losses to the market. On joining AIG in 1985 most of my time initially was spent managing claims arising from seemingly every emerging market being in default on its sovereign debt. Famously, before Mexico defaulted, the chairman of Citibank (Walter Wriston) had said “Countries don’t go bust”. That theory was tested to destruction. The loss ratios across the market were horrendous, and our continued existence as a specialty line hung in the balance with powerful voices arguing that insuring sovereign and political risk was inappropriate for the commercial insurance market. Fortunately, the market managed to reinvent itself, largely by diversifying into other types of business (reducing dependence on banks, and attracting other types of clients such as commodity traders) thereby bringing greater diversity into their portfolios. The benefits shortly became apparent and by the close of the 1980’s the market was making substantial underwriting profits again.
- 1990. On or around 1990, the market experienced a “cluster” of major events, each of which would have been difficult in isolation and that taken together were extremely damaging. However, unlike the 1980’s sovereign debt crisis, the 1990 “cluster” never posed a threat to the existence of the class. Much greater diversity and much larger premium income volumes ensured that this was weathered successfully.
- The break-up of the USSR. Debt (in particular FTO debt) that was previously considered “sovereign” and that had been insured by PRI insurers was deemed non-sovereign by Russia after the USSR collapsed.
- The Yugoslav civil war. Large claims on ship building contracts in Croatia.
- The first gulf war.
- 2000. Again, a “cluster” of events, occurring on or around the start of the new decade.
- Argentine devaluation and default.
- 2010. The Financial Crisis. (admittedly, this reached its crisis point in Q4 2008 but that is within 15 months of the start of the next decade and so I consider it legitimate to categorise it as an end-of-decade major event)
- 2020. Covid-19.
Some of the notable “local difficulties” that cropped up between the end-of-decade major events include:
- The Asian Crisis
- The Russian Devaluation
- The end of the commodity super-cycle in 2014
- Latin American expropriation pandemic mid to late 1980’s.
In case the preceding examples gives an impression of a market always on the brink of catastrophe, I must emphasise that Political Risk insurance (Contract Frustration and CEND) has been overwhelmingly profitable for underwriters. Lloyd’s figures for the period 1997 to the present show Gross Premium Written of £2.6billion with paid losses of £0.98bn; a loss ratio of 37.8%.
So, in retrospect we should not be surprised to start the new decade with a major crisis affecting our market. But how bad this might be in the context of previous major events?
Structured Credit Insurance. This could obviously be pretty bad, for the obvious reason that much of the global economy has closed down. Previous economic downturns have normally not affected all sectors of the economy or the global community. Recessions in the manufacturing sector have usually not been accompanied by distress in the financial services sector, for example. Problems in Asia in the late 1990’s were not experienced in Africa or Latin America. Covid-19 is very different, shutting down entire economies, affecting all parts of the globe, and affecting virtually all sectors. Our market is perhaps additionally vulnerable because it insures a great deal of oil related business, and the collapse in the oil price has the potential to inflict much pain.
However, there are reasons for cautious optimism:
- First, the position facing insurers will become clear very quickly. I anticipate that within 12 months the scale of the problem will be clear, reserves can be established, a line drawn under the problem and credit insurance business can pick up again in some form or other. There may be casualties, and the market appetite that emerges from Covid-19 may be somewhat different from what we have seen over the past decade in terms of size and risk appetite, but it should nevertheless bounce back.
- Second, there is potential for government support for the industry. I understand that the Dutch government has effectively “nationalised” the credit insurers in the Netherlands. Every insurer, including I understand local offices of UK MGA’s, must cede all premium written in 2020 to the government, who will henceforth assume responsibility for claims. It will pay the insurers a fee for managing and servicing the book. Essentially, Dutch credit insurers have all become MGA’s writing on behalf of the government. That is an interesting and imaginative development which if adopted more widely could go a long way to safeguarding the credit insurance industry, and perhaps more importantly ensuring the access to trade credit that is vital for most corporations. (NB, at time of writing it is not clear whether this support is being provided just for WTO business or whether it also extends to the Structured Credit business).
- Third, this is a very mature sector of the insurance industry. Many of the lead underwriters have been in the business for thirty plus years, and have traded successfully through previous crises. The senior management of the Private Market (in both underwriting and broking communities) has impressive reservoir of knowledge, experience and wisdom.
- Finally, previous crises have tended to look initially more alarming than was eventually the case. Whether Covid-19 will follow that pattern is uncertain, but if it is resolved in the near term (i.e. provided it does not drag on into the winter) there must be some hope that the crisis will be less severe than the worst projections.
How bad this will be for insurers will depend on the following:
- How quickly lockdown is ended, and normal business resumes; not just in Europe and America, but also in Africa, MENA and Asia.
- How quickly oil prices recover.
- The extent and effectiveness of government support for the credit insurance industry, and for the Private Market in particular.
- The approach taken by the banks, who by most estimates generate 70% plus of the market’s business. The hope is that bank Assureds will take a long term view, and support obligors in difficulty without triggering default (by relying on covenant breaches for instance) and claiming under the insurance. This is at present unknowable.
I expect the pain to be less than the worst forecasts. I believe most banks will act intelligently and responsibly, looking for ways to support customers and not to drive them into default. Some, no doubt, will behave less well. I expect governments to act in a coordinated manner to mitigate the threats facing credit insurers. And I expect the picture to become clear in a relatively short time frame. I am not trying to belittle what is obviously a major crisis for our market, but I draw encouragement from the mature and experienced management of the underwriting (and broking) teams, the good relationships and common understanding with many of the largest clients, most of whom favour pragmatic long term work-outs and restructurings of troubled situations allowing problems with obligors to be worked out in an orderly manner, often by extending the time to repay the loans in question. Such a supportive approach will be crucial in mitigating the long-term damage of covid19.
As an aside, though, I have often lamented the absence of any meaningful industry association specifically representing the interests of the Private Market. Perhaps Covid-19 will change that. Right now, some lobbying capacity with the regulatory and governmental decision makers has never been more important, and I am not sure we have that capability to the extent necessary. I fear that while governments may provide emergency support to the Whole Turnover credit insurance market, we will not benefit to the same extent. We are not as recognisable. We have too low a profile.
Contract Frustration (CF). This has the potential to be as painful to the Private Market as Structured Credit; possibly more so. I also believe that the timeframe for being able to assess the eventual severity (and the likely cost) is going to be more extended. The most commonly covered risk under a CF policy is non-payment by foreign governments, either arising from short-term contracts between the Insured (usually a contractor) and a Public Body, or from long-term loans extended by banks and multilaterals to the sovereign (i.e. Ministry of Finance) to finance infrastructure investment (a new airport, road, hospital etc.)
CF business probably accounts for a similar level of exposure as Structured Credit for our market split roughly 50/50 between short-term, sub sovereign (i.e. public body) and long-term sovereign (i.e. Ministry of Finance) business. The problems associated with countries running into financial difficulties as a result of Covid-19 will be slower to make themselves felt in our market than will be the case for structured credit. Unfortunately, though, they have the potential to be just as severe in the long run unless there is determined and coordinated support from multilaterals and governments. With that in mind, I offer the following thoughts:
- Short term CF (public body / contractor Insured business) should be less problematic than long-term sovereign debt business. Critical work performed by contractors will largely be paid for over time, as governments draw a distinction between bank creditors / long-term sovereign debt and short-term supplier / contractor debt. That said, it will be no holiday and substantial claims are likely, in no small measure due to the market’s exposure to oil and energy which will be hard hit unless there is a swift and meaningful rebound in crude prices.
- Long-term sovereign debt is vulnerable for the following reasons.
a) Sovereign debt levels have increased steadily in many of the markets key risk countries in recent years, thereby increasing the potential for debt repayments becoming unsustainable as GDP falls off and exports of commodities (oil especially) suffer from massively reduced prices. Over the last decade, many countries took advantage of rising commodity prices and falling interest rates to access international debt markets after receiving debt relief in the prior decade. For example, thirty countries from western to eastern to southern Africa reduced their average ratio of external debt to GDP from 121.3% in 1998 to 27.6% in 2011 only to see the average rise to ca. 39% in 2018. However within that group, a number of key countries for our market saw large increases in this ratio such as Zambia (four times to 73%), Mozambique (two times to 108% and Angola (two-and-a-half times to 54%). Angola is perhaps the market’s largest CF exposure. Three out of four of these countries are dependent on a range of hydrocarbon, mineral and agricultural commodities for 40% to 90% of export earnings, most of which commodities are under serious price pressure in the current environment.
b) Many key countries (Angola for example) have substantial debt repayments coming up in the next few years. Ordinarily, these would be refinanced but in the current climate that might not be possible.
c) Most sovereign lending is subject to “Cross Default” provisions. Simply put, this means that if Country A defaults on a loan to Bank B it is automatically and immediately deemed to be in default to all other creditors of a similar type. Most commercial bank loans will additionally be “cross defaulted” to ECA and Multilateral loans. The effect of this is that once Country A has defaulted, most CF Sovereign policies will be the subject of a default leading to potential claim simultaneously. Factor in, also, the contagion effect whereby other countries with similar economic dependencies suffer the same financial difficulties, and this could get quite nasty.
d) All of this will take some time to play out, and possible restructurings will be painfully slow to arrange given the number of institutions (both commercial banks, ECA’s and Multilaterals) who will have an interest.
All of which sounds pretty depressing. However, it is to be hoped that the international community (and in particular the multilateral institutions) will work in tandem to arrange sufficient support and liquidity to mitigate the worst effects of Covid-19 on vulnerable economies, and to provide enough liquidity and relief to enable countries to get through the crisis. If this is handled in a coordinated and supportive manner it is possible that a widespread sovereign debt crisis derived from Covid-19 can be avoided, or significantly mitigated. But “debt moratorium” is already being referenced by political leaders, and some level of “haircut”, write-off or rescheduling is potentially on the cards. This has the potential to be bad, but (as with Structured Credit) it also has the potential to be managed effectively in such a manner to avoid a 1980’s style sovereign debt crisis.
The critical factors that will decide the severity of Covid-19 on our market will be similar to those that will determine the outcome on the Credit book. How long the crisis persists, the extent to which oil prices recover, the long-term effect of Covid-19 on the country’s GDP, the decisions that governments and multilateral institutions make in aiding (or abandoning) poorer countries through the crisis. As with Structured Credit business, the attitude of the bank and multilateral Assureds will be a decisive factor in how this plays out for underwriters. I expect that most will be looking to support foreign governments through the resultant financial difficulties, and will be asking insurers, in turn, to support them by extending repayment periods (and thus policy periods) and taking some limited financial “haircuts” to avoid full blown default. As such while there may be some pain it will not be catastrophic. If I am wrong in my prediction on the behaviour of banks and multilaterals, though, the picture will look different.
Political Risk (CEND). Finally, we come to “Confiscation, Expropriation, Nationalisation & Deprivation” or CEND for short. These policies cover foreign direct investors (such as owners of businesses domiciled overseas) and owners of mobile equipment (located overseas, often to perform contracts) against the loss of those assets and investments due to political and security risks, the main ones being expropriation and forced abandonment. This part of the Private Market’s activities should be relatively immune from the worst effects of Covid-19, with only a few potential problem areas immediately being apparent:
- Non-Transfer and inconvertibility of earnings from the investment is potentially going to be more difficult if the Host Country encounters capital flight and USD shortages.
- Large project and concession risks (e.g. where the Assured has a concession to run a toll road) have the potential to become troubled if the project sponsor is unable to make the promised investments, thereby prompting the Host Government to take the concession back into public ownership, or to step in to manage the project itself. In such circumstances there is always potential for the government’s actions to be in breach of previous legally documented undertakings, or to fail the test of prompt, adequate and effective compensation.
- Political violence could increase in line with increased impoverishment of the local population (the two often go hand-in-hand)
The majority of foreign direct investment should continue to be welcomed at senior levels in the Host Government, being recognised as a key driver of economic development, jobs and FX earnings. That does not mean, though, that the risk environment will not have deteriorated. There are four factors at play that could generate significantly increased risk towards foreigners and foreign investment.
- First, feelings within the general public (as distinct from the government) could become more hostile towards foreign investment and foreign businesses. I worry that if the richer nations (the G7 in particular) are perceived as being insufficiently supportive, turning inwards in an effort to protect domestic jobs and the domestic economy at the (perceived) expense of poorer nations who are left to fend for themselves, it could seriously impact the way in which foreign direct investment is viewed.
- Second, how foreign owned businesses behave in the weeks ahead as the virus sweeps across poorer countries, could affect the longer-term attitude towards Foreign Direct Investment. Furloughing workers, closing factories etc. Insensitive behaviour by one or two prominent foreign owned employers of labour could impact more widely on how foreign businesses are perceived.
- Potential for violent change of government. Many countries face a bleak economic future in the event the crisis is not resolved shortly. One respected sovereign risk analyst has just produced a table of countries most at-risk from Covid19 and oil price vulnerability. The twelve most affected countries are listed below two of which have experienced attempted coups in the past five years. The potential for similar coup attempts over the next three years must surely increase as a result of the current disruption.
- Mozambique (the worst affected) followed by
- Sao Tome & Principe,
- Turkey, Azerbaijan and
Many of these countries (as well as other exposed countries further down the list that I have not reproduced) have significant levels of foreign direct investment.
- Finally, as companies reconsider their current supply chain and just-in-time business models and as “globalisation” potentially loses favour in both corporate and governmental circles in the G7, some countries stand out as potentially major, big time, losers in this game. Other countries and regions, paradoxically, could be major net beneficiaries. Those investors who chose to remain in countries which experience investment flight could well find the business climate turn increasingly hostile.
- Compared with previous “major events” (that arise, uncannily, at the start of every decade) Covid-19 is likely to be more severe, but it is not likely to be catastrophic. Clients, governments, multilaterals are likely to manage their responses in such a manner that insurers mainly play a role in supporting the transition to a post Covid-19 world, as opposed to writing a massive cheque to finance a “cut-and-run” abandonment by our clients. That said, I am sure certain clients will decide to “cut-and-run” possibly as a consequence of (say) a bank exiting the line of business in question, and the client base of our industry may look very different when this is over.
- Notwithstanding conclusion 1 above, this will be very painful. But the pain has to be viewed in the context of a business line (Political Risk encompassing CF and CEND) that generates $3bn premium to the Private Market annually and that has enjoyed a gross loss ratio of 37% over the past twenty years. The market will survive this, but there will be pain.
- The behaviour of governments and multilateral institutions will be decisive in determining the severity of the claims spike that will arise from Covid-19.
- Of the three business lines that comprise the Private Market’s livelihood, CF and CR are the most exposed. The situation with Credit should become apparent quite speedily, while the position for CF is likely to be slow to crystallise.
- The position with PR/CEND is likely to be benign from an immediate claim’s standpoint. The main flashpoints are likely to involve increased political violence and difficulties in remitting earnings out of the Host Country. Longer-term, though, the risks facing foreign direct investment is likely to increase in line with the increased instability and poverty that Covid-19 seems likely to inflict.
If poorer countries of the world are to recover from Covid 19 quickly, a speedy resumption of trade and investment between local businesses and their key trading partners in G7 type countries will be crucial. Our market has long provided extraordinary levels of support for these trade and investment flows, and it will never have been more important for that we continue to provide that support once Covid19 is behind us.