Banks across the Asia Pacific (APAC) region are feeling the pressure. A slump in loan market volumes and an abundance of bank market liquidity have resulted in margin compression even in an era of high interest rates. Bad debt provisions are on the increase, particularly in relation to commercial property. Even the region’s economic outlook feels more uncertain than it has for many years.
Against this difficult backdrop, how can banks in the region manage their risk more effectively? One valuable option could be non-payment insurance (NPI) – an insurance product that protects against the financial consequences of default by a counterparty such as a borrower, guarantor, or another party to any debt instrument (including loans, bonds, derivatives and project finance, for example).
By using NPI, part of the bank’s credit exposure is insured by a specific insurance company or a syndicate of insurers. The NPI policy provides the bank with much greater certainty that, in the event of a non-payment by the borrower, the debt will ultimately be serviced - by the insurer.
In many parts of the world, NPI has developed into a key risk distribution tool for banks, allowing them to take on credit risk with greater confidence. An important characteristic of NPI is its undisclosed nature; the bank “holds yet distributes” the risk, enabling it to:
Having credit risk insurance cover also eases the pressure on banks with regards to their capital reserving responsibilities. By purchasing NPI that meets certain minimum eligibility requirements, banks are able to secure a risk-weighted asset (RWA) benefit in accordance with the Basel framework, thereby reducing the minimum capital hold required for the insured exposures.
What is the current state of APAC’s NPI market?
Banks in APAC have traditionally shown relatively little interest in NPI. While the global NPI market is estimated to be worth more than $160 billion, APAC domiciled banks account for less than 15% of this total .
There are good reasons for this. APAC banks have not faced the same regulatory imperatives on balance sheet strength as their Western counterparts. In any case, the region’s banks have historically been well-capitalised. This has also meant availability of a very active secondary bank market for distribution. Awareness and understanding of NPI has therefore been lower than in other Western markets.
Today, however, the market dynamics are shifting. The case for APAC banks to add NPI to their risk management toolset looks increasingly strong.
Not least, the economic and commercial backdrop suggests a new approach to managing credit risk may now be needed. The real estate crisis in China has already seen property companies default on $140 billion worth of dollar bonds – and there is expected to be more bad news to come . Other APAC markets are beginning to worry about similar sorts of problems as the contagion spreads.
One solution is for banks is to pull back from the APAC region. Some have already done so, with a number of institutions substantially reducing their exposure to the region or pulling out of certain markets altogether. However, even with uncertainties to deal with, the case for continuing to invest in the APAC region remains a compelling one. The International Monetary Fund expects Asian economies to continue to outperform the rest of the world in the years ahead. Banks in search of growth and profitability are reluctant simply to steer clear. Indeed, some are looking to increase their exposure, or at least to protect operations in the region from cuts made globally. Effective credit risk management will be a key factor when making strategic investment decisions in the region.
As for APAC’s domestic banks, they do not have the option of quitting their own region. This is prompting these institutions to think harder about how to manage their risk, both at home and in international markets including Europe and North America.
NPI may offer many of the answers to the APAC banking sector’s questions. It offers a robust and flexible means to distribute some of their risk exposure; this may enable them to retain or even increase their exposure to APAC and for the domestic banks to venture into newer markets.
Why else should banks in APAC consider NPI now?
There are also other arguments for APAC banks to consider NPI for the first time (or to return to this market if they have used it before). Insurance is a powerful way to distribute risk at a time when many banks in the region are under pressure to take on different types of exposure.
For example, the nature of lending in the region is changing, with banks increasingly expected to consider asset classes like subscription financing, NAV financing, margin loans and private credit, that might once have been well beyond their risk appetite. The structure of deals is changing too, with leveraged finance becoming increasingly common. NPI can help banks participate in new asset classes or with larger holds while remaining comfortable with their exposures.
Moreover, the rapid expansion of private credit funds into APAC is increasing competition across the region. Banks must fight hard for every transaction – NPI could be a key factor in their ability to remain competitive.
Indeed, insurance could unlock opportunities for banks participating in the secondary market to play a bigger role. Some banks are typically expected to operate as secondary liquidity providers on syndicated deals, because they lack the balance sheet strength to lead the deal. These institutions may be able to take the lead bank position if they can use NPI to distribute some of the extra risk.
What is the downside?
Banks will clearly need to consider the cost of NPI as part of any concerted move into this space. And it’s fair to say the market is currently relatively tight in APAC – specialist support will be required to secure competitive rates, desired policy limits and attractive terms.
It is also important for users of NPI to invest in ensuring the product is used effectively – for example, conducting internal training and establishing operational processes to ensure compliance with key policy terms. Where a bank has no previous experience using credit insurance, a lack of understanding by key internal stakeholders can be an initial barrier to establishing an NPI program that must be overcome. Fortunately, the fact that the product is already used extensively in many markets means that banks can leverage a wealth of available market knowledge, including that of specialist NPI brokers.
Banks are also taking on a different type of exposure by working with an insurer; NPI carries the risk of a default from the insurer itself. However, it is important to note that many insurers are AA-rated by credit rating agencies such as S&P, helping banks to get comfortable in this area.
As an upside, it’s worth pointing out that this insurance now has a proven track record in the APAC market. For example, a number of banks have made successful claims on NPI in relation to payment defaults by APAC borrowers and obligors. In other words, the product works – when the bank’s borrowers don’t pay, its NPI steps in.
How do banks choose an insurer?
The good news is that this is an increasingly competitive market. In London alone, more than 60 providers rated between A and AA now offer NPI, and this healthy level of competition keeps costs down. New insurers continue to enter the market, and capacity is expected to keep growing.
Banks that regularly use NPI typically develop fairly standardised templates for the insurance they want to buy. Having a template wording offers significant benefits, reducing legal costs and allowing new policies to be placed more quickly. These templates can then be adapted for each individual transaction as is required. An insurance broker will help the bank find the insurer best suited for each deal, based on the price and terms available in the market at the time.
Most banks opt to limit their overall exposure to individual NPI insurers. This reduces their counterparty risk – the danger that an insurer may not be able to fund a large claim. Luckily, the number of providers in the market affords bank users a high degree of flexibility. It is also common to see syndicated insurance placements, where a number of insurers insure a single deal on a several basis, each taking a proportional share of the total policy limit.
Banks’ secret weapon?
The bottom line is that while NPI is a relatively nascent – and often unknown – market in APAC, there are compelling reasons for banks to now explore this further. It could be a valuable distribution tool for clearing underwritten positions or managing back-book assets. The experience of banks that have used NPI in other parts of the world has been very positive, enabling them to distribute risk efficiently and effectively. In the rare event of a default, claims have been paid in full and on time.
As yet, relatively few banks have pursued the same strategy in APAC – largely because they haven’t needed to. But with the landscape now shifting markedly, NPI could provide banks with a crucial competitive advantage. Some APAC banks are already preparing to make use of NPI, or increase their current usage. This approach has the potential to help them secure a real advantage – and make all the difference as they continue to compete in a challenging market.
If you would like to discuss how non-payment insurance can help your organisation mitigate macroeconomic risks, please get in touch or contact your local WTW representative.
