The last two years has been a rollercoaster ride for the commodities market and the whole commodities supply chain: lenders, manufacturers, commodity traders and distributors. Lenders have been hit hard by defaults on repayment obligations in funding agreements with Covid-19 closing down businesses causing financial hardship and insolvencies affecting the ability of borrowers to meet their financial obligations to lenders. The impact of such defaults is widened by the pressure placed upon corporate or personal guarantors.
The use of insurance products to mitigate the risks faced by lenders and borrowers provides a vital risk management tool for de-risking investments and enabling businesses to invest in industry sectors or in jurisdictions which they might not have previously done. The presence of insurance not only de-risks counterparty risk, insurance can also have the benefit of lowering the cost of monetary lending for borrowers.
The hardening of the insurance market, which was well underway before Covid-19 has affected the number of insurers prepared to offer credit insurance and the terms on offer, but insurance is still available. We have been and continue to advise clients on both insurance coverage disputes in relation to trade credit insurance policies and also provide advice to clients on the terms of the insurance cover they are being offered and whether those terms are appropriate to the risks they require insurance for.
What type of insurance product?
The value of an insurance policy is only as good as the terms and conditions contained within it. In many cases borrowers and lenders who have taken up such policies have adopted a tick box mentality, without considering in detail the scope of the insurance and how it operates. There are different types of insurance products covering an array of different risks. So, to ensure the effectiveness of any risk management strategy which includes or is based around trade credit insurance, it is important to ensure that the correct insurance is purchased.
The starting point is to focus on the type of risk that is required to be covered. If a one off, large transaction, a bespoke policy specifically tailored to the transaction terms and the jurisdictions involved is likely to be the preferred option.
On the other hand, if the trading required to be covered is focussed on regular selling to regular customers then a receivables based / whole turnover insurance product is likely to be more appropriate.
However, both types of insurance product require considerable thought before purchasing to ensure its terms are right for the business / project. The insurance at first might appear broad but do the conditions and exclusions significantly narrow its effect.
What type of cover?
There are many perils or risks that fall for consideration or that might be factors in the underlying business requiring the funding.
- Counter-Party Risk: what is the risk that might lead to defaults? Late payment, non payment or insolvency of customers;
- Jurisdictional / governmental risks: these include the risk of nationalisation, confiscation, expropriation and deprivation;
- Civil Risks: Riot, strikes, civil commotion and malicious damage;
- Political Violence: insurrection, rebellion, revolution, mutiny or coup d’etat; civil war and war; and
In some cases the assessments of what risks are required to be covered are straightforward, however if the investment is a project finance based abroad or a trade finance into a company operating across many jurisdictions the risks can be complex.
Another factor when considering different jurisdictions are local insurance regulations and laws. In many overseas jurisdictions there is a requirement for insurance covering local risks and interests to be placed locally or what is sometimes referred to as a fronting policy issued locally. In some less developed jurisdictions, the capitalisation and sophistication of local insurers (including lack of experience in managing unusual insurance policies and claims) can increase the risk of reliance on or negate the effectiveness of the risk mitigation strategy built upon insurance.
Parties to the Insurance Policy
Who is a party to the insurance policy? This might at first appear a mundane issue, however it is an important one.
In many cases lenders seek to rely upon their position as a loss payee under an insurance policy in order to secure their interest and to protect against the risk of the borrower defaulting on their repayment obligations. The rights of loss payees have been litigated many times through the Courts. Loss payees’ rights under insurance policies are dependent upon the rights of the insureds, such that should the insured do something which might entitle an insurer to decline to indemnify an insurance claim, then the loss payee has no right to challenge that decision.
It is not always clear from an insurance policy whether a party is a loss payee, a party to the insurance policy or an insured. We have advised on policies where a party is not only named as the party to receive the insurance policy proceeds but has other rights and obligations under the insurance policy.
The risk to a loss payee’s position has driven lenders to require being named as co-insureds in order to preserve their rights under an insurance policy. However, such policies need to be carefully considered in order to assess whether the naming of a lender as a co-insured works. In a number of instances we have been instructed to review and report to a client on the adequacy of a trade credit insurance policy, where an insurer has agreed to name the lender as a co-insured but has not reviewed or adjusted the terms of the insurance policy to reflect the addition of the lender and their interest in the insurance policy.
In addition to the above, lenders increasing seek to purchase their own insurance protection as a fall back position, such insurances paying only after the original or underlying insurance has been called upon to pay.
For complicated transactions, the best approach might be for a bespoke insurance policy which is drafted to fit the risks of the transaction to be covered. This can often cost more and requires more management time but provides a greater degree of comfort that cannot be matched.
The front loading of management time and costs involved in an insurance policy review to ensure that the insurance cover reflects the risks for which it has been taken out is important and worthwhile. Such costs can be added to the cost of lending to ensure that lenders are not footing such costs.
Onerous Terms and Conditions
Trade Credit (and Political Risk) insurance policies often contain onerous obligations.
It is not unusual for insurance policies, certainly for the receivables / whole turnover insurance policies to have pre-qualifying requirements which n policyholder is required to comply with to ensure it comes within the terms of the insurance cover. Such requirements can include:
- Credit Limits: Insurers can set credit limits for particular customers or counterparties of an insured borrower. This effectively limits the insurance provided to underlying transactions that fall within the credit limits. insurers can often withdraw or vary credit limits, usually only with prior consultation with the policyholder, however the notice periods can be short. As a result, policyholders need to regularly review the credit limits against the underlying transactions to ensure the transactions come within the insurance policy requirements;
- Retention of Title clauses: invariably there will be a requirement for the policyholder to include retention of title clauses or some form of contractual entitlement to the goods the subject of the underlying transaction. On a commercial level this can cause difficulties where a customer / counterparty is in a country in which it may be difficult to enforce such clauses.
- Geographical limitations to the cover: for global businesses trading internationally there are usually limitations and exclusions in relation to providing services or the selling of goods to customers / counterparties in certain territories.
- Invoicing: it is not unusual for policies to require a set time by which invoices need to be rendered to customer / counterparties.
Trade Credit Insurance policies do contain onerous obligations on policyholders and also lenders. All parties to the insurance policies need to be fully aware of their obligations and some can be easily breached which may entitle insurers to deny an insurance claim. Such obligations might include:
- The obligation not to alter the terms of the borrowing or underlying contracts without obtaining an insurer’s consent;
- The obligation to only use the funds lent for the purpose intended. If such a question is asked by an insurer the policyholder needs to have an ability to evidence that the borrower has complied with such obligations;
- Reporting Obligations. Policyholders should be weary of reporting obligations. These can be in relation to protracted default covers where there is often a requirement to notify insurers that payments are overdue by a certain time. In addition, there are often reporting obligations concerning a borrower’s or a customer’s financial standing and awareness of circumstances that might indicate a deterioration of that standing. Furthermore, there are often strict temporal notification requirements which are usually a condition precedent and require strict adherence.
- Obligation to prevent and / or minimise loss. Invariably there will be obligations upon the policyholder to prevent and / or minimise losses. The requirement to do so is usually for the policyholder to take “all reasonable steps” or “appropriate” steps and what constitutes “reasonable” or “appropriate” often depends upon the circumstances. The customer or counterparty might not have any assets to enforce against. Also, the counterparty might be in a jurisdiction in which the availability of legal remedies are limited. Case law exists which supports the argument that a policyholder can take into account their commercial interests when deciding if a certain step is “reasonable” to prevent/minimise loss. Care should be taken when deciding what mitigating steps to take. For example, the strategy of re-issuing invoices or accepting a lesser amount for a loss will provide insurers with reasons to limit or decline an insurance indemnity.
- The calculation of and evidencing the loss to be indemnified. Trade Credit insurance policies can often necessitate complicated calculations in order to understand the amount to be indemnified, particularly the identification of the date on which the loss crystallises. The date at which losses crystallise can have marked effects on insured loss under the insurance policy and clauses in the policy may vary as to how recoveries are dealt with. Similarly, the requirement for detailed supporting documentation to evidence the loss can place on policyholder an onerous filing and administrative burden.
Certainly the advent of the Insurance Act 2015, applying to all English law policies, and the requirements for certain conditions and warranties to be causative of the breach if insurers are to rely upon policyholders’ breach, has provided a significant support for policyholders in insurance coverage disputes, where previously breach of condition precedents and warranties were fatal to a policyholder’s insurance claim, and for breach of the latter rendered a policyholder without insurance moving forward. It is important to consider the governing law of the insurance policy and where there is the opportunity to agree upon a governing law which provides support to a policyholder, such as the law of England and Wales, for such an opportunity to be taken up.
As the world starts to re-emerge from the pandemic and commerce looks to borrow to enable it to invest in growth and new ventures, the use of trade credit insurance is one of the risk management tools available to a lender or borrower to mitigate the risks of borrowing but supporting their business. However, in order to ensure the certainty of the insurance being purchased, it is well worth taking the time to consider what is being purchased and how it fits with the risks faced.