Trade Credit Insurance is a relatively straightforward product. Trade receivables are one of the most vulnerable assets of businesses and non-payment can have significant, negative impacts on both their commercial success and long-term survival. Failure to receive payment can create liquidity problems for companies and even lead to a domino effect of failures through supply chains and trade networks. Getting to grips with how it functions and its benefits for economies is clearly an important thing for governments to understand.
The recent analysis of the sector published by the European Systemic Risk Board in August therefore warrants some attention as an important step in this direction within the EU. The paper sets out the views of the ESRB on the role of TCI in the economy, its benefits to trade and commerce, the structure of the market, the impact of crises such as the pandemic or Global Financial Crisis, and its perception of potential sources of systemic risk related to the sector. The paper concludes with several possible policy suggestions that the EU and/or member states could consider mitigating this perceived systemic risk.
ICISA has engaged with several European Union institutions, including the ESRB, since the start of the pandemic to help with their understanding of the sector. As a small, but important element within the global specialty market, knowledge of credit insurance has not always been as strong among regulators and policymakers as other lines, such as Life, Motor or other direct-to-consumer insurances. While this is understandable, ICISA sees one of its core aims as helping to improve this situation in a balanced and objective way.
So, what does the analysis say? The note sets out the basis of the ESRB’s understanding of how trade credit insurance products work and why they are used by companies to mitigate the possible loss of income through non-payment of receivables. As part of this, the ESRB points out the value brought to the real economy by the availability of the protection from trade credit insurance. This includes the flexibility that the product provides to policyholders in support of their individual growth plans.
The ESRB also correctly highlights the important role TCI plays in supporting credit risk management of policyholders, as well as its additional benefit of improving access to finance. While they note that TCI is generally utilised by larger, rather than smaller entities, in reality this is not uniform across all markets. Within the EU, the segments where TCI is most widely used can vary quite substantially.
Indeed, ICISA pointed out that recent changes by DG Competition to the Short Term Export Credit communication to expand its application to larger SMEs could have a distorting effect on the market. This is because the increased cap under which state-backed insurers (ECAs) can compete with private TCI players now includes an SME segment for which there has been ample cover available in some markets, particularly those in Southern Europe.
The note also describes mechanisms available to trade credit insurers to reduce exposures, noting that cover may be withdrawn at short notice if there is a deterioration in the credit worthiness of specific buyers under a related policy. ESRB notes that this can occur after a grace period and also identifies that shipments made prior to the decision to withdraw a limit are still covered under the same policy conditions as before. It recognises that withdrawal of coverage in this way is understood by policyholders and that it is in the interest of the policyholder to maintain strong credit controls and debt management. This would help to avoid alterations to limits and financial loss on the part of the policyholder and the insurer in case of default of the buyer.
The paper also describes the availability of non-cancellable limits within the market, suggesting that there is greater certainty for the policyholder. However, this perhaps only gives a partial understanding of how such policies function in practice. The non-cancellable nature is governed by strong risk management considerations of both the insurer and the policyholder, which are clearly set out in the policy wordings. For instance, when a buyer does not pay on the due date of previous invoices, the cover becomes void for new deliveries as defined in the policy, rather than at the discretion of the insurer. The same happens when the buyer becomes insolvent, but is still trading under a liquidator.
A further important element in the paper is to note that TCI is identified as a critical function under criteria briefly outlined in the paper. While the idea of a critical function is drawn from a framework developed by EIOPA, for the ESRB, insurance critical functions are seen as a potential transmission channel for systemic risk.
While the ESRB notes that there was no unanimity among ESRB member institutions on whether to consider TCI as a systemic risk, the note provides some detail of the criteria used to identify where such risk may arise. This includes the nature of the policyholders involved (i.e. sellers), the potential impact of market disruption or dysfunction, and potential impact on tax payers. However, while the ESRB’s position is clear, it is known that in Germany the government intervention in the credit insurance market during the pandemic actually resulted in profits for German tax payers. While data on other markets is not publicly available, anecdotal evidence suggests a similar picture elsewhere. More broadly, it would seem reasonable that more work is to be undertaken with the cooperation of the industry on understanding whether these labels can be fairly applied to the sector. This will also support and inform better policymaking towards the sector.
While the ESRB’s overall description of aspects of the sector and the market is accurate, there is limited recognition of the lack of homogeneity across the EU in different member states’ markets. This is particularly true for which kinds of companies use TCI in each market and how markets perform and react to different circumstances.
This also suggests that the policy options available to governments across the EU will necessarily have to be different, and a one-size fits all approach may not address specific issues in individual markets. While ICISA called for greater coordination of approaches from member states during the pandemic, noting the various problems that could arise in its absence, a one-size-fits-all approach would also not seem to address the diversity of markets across member states.
What then does the ESRB recommend as possible avenues for policymakers? The paper rightly identifies that ad hoc approaches, such as those adopted during the pandemic, are likely to lead to sub-optimal results. As identified in research by ICISA, while the government reinsurance schemes introduced during the pandemic had an early positive impact on markets by giving clarity and certainty, these lost value over time. This occurred in our view because the weight of direct provisions targeting systemic weaknesses in the real economy itself were more impactful, while also cancelling out the intended effect of intervention in the credit insurance market.
ICISA has called for greater thinking in advance of future crises about what steps governments wish to take. Key to this will be early identification of the type of crisis, how it will impact liquidity in the real economy, and which sectors are likely to be the most negatively impacted. From there, targeted and pre-planned interventions may be beneficial at providing certainty to businesses about their survival in a time of crisis, as well as providing clarity to credit insurers about how to appropriately manage exposures when other indicators suggest buyers may have reduced creditworthiness. The experience from the pandemic shows that governments have a difficult decision about whether blanket support is appropriate even for businesses that would likely not have survived in normal conditions without such support. This also applies for decisions governments make about whether to prevent credit insurers withdrawing limits from companies with increased default risk.
The ESRB highlights a harmonised reinsurance arrangement as one possible approach, although there is limited reference to the expected function of private reinsurance markets, which already provide significant capacity to the sector, and how these would interact under such a model. Further work is required on all proposals, including assessing their pros and cons, but now is the time to consider such matters in more depth. Indeed, the ESRB’s own comment about the impact of such proposals on reducing moral hazard are noteworthy and will need to be considered under any plans prepared or introduced. In particular, ensuring that those companies receiving direct support are continuing to manage risks appropriately is key. Similarly, ensuring that winding-up and resolution mechanisms remain functional will also be important under any future plans.
A further suggestion put forward by the ESRB in its note is the possibility for wider use of non-cancellable limits within the private market. While such policies are a valuable tool for some clients and particular circumstances, they will not be appropriate on a blanket basis. As the ESRB notes itself, this approach could lead to a reduction in moral hazard, however, it also notes that this could lead to policies becoming unaffordable due to the need for different pricing models.
Increased moral hazard and pricing-out of significant portions of the economy are indeed problematic and likely outcomes. While there is no suggestion in the paper that this approach would be imposed by governments or regulators, such a switch to non-cancellable cover by the private market seems unlikely. Altering approaches in this way would represent a fundamental change to the fabric of the market as it operates today without added benefit to a wide class of policyholders or their insurers. The ability to cancel limits where creditworthiness has diminished substantially is an important safety valve not only for the insurer, but for the policyholder too, who retains a part of any loss. Such a radical change in the market would also likely see many insurers consider whether to continue to operate in the marketplace at all. This is because switching business models to this degree would require significant and costly changes to underwriting, reinsurance purchasing, distribution, modelling, claims management and other core operational elements of insurers.
While the ESRB notes that some businesses may be priced out of purchasing TCI if there was wider use of non-cancellable limits, it is also possible that some businesses which are able to purchase cover today would not be offered non-cancellable cover due to the product being inappropriate for them. Non-cancellable cover requires demonstrable credit management knowledge and practices on the part of the policy holder. Especially in the case of SMEs, this is often not present nor practical to implement at significant scale. Indeed, this is a major reason why many SMEs purchase standard trade credit insurance policies in the first place. This allows for outside support of credit and wider risk management and is beneficial to the policy holder and for resiliency in the economy at large.
While there are concerns about some of the proposed policy suggestions in the paper, ICISA agrees that more work needs to be done as a collaboration between the industry, policymakers and regulators. This includes working closely together to build greater awareness among stakeholders about the nature and structure of the TCI market. As noted above, this also includes further work to understand whether labelling the sector as a “critical function” with elements of systemic risk is in fact accurate and appropriate given the data and other information available to us. Furthermore, addressing wider gaps in data – both within the industry and from policymakers/regulators on trade credit – will also be necessary before firm decisions on policy can be taken in the context of different scenarios. ICISA is pleased to take part in all such discussions to find the best solutions for policyholders, insurers and the wider economy, so that TCI can continue to play its role facilitating and adding value to trade.
