The impact of interest rates and inflation on credit and political risks

As the global economy continues to feel the effect of the global pandemic and the ongoing war in Ukraine, world economies are now also facing a need to balance interest rates with rising inflation.

Leading economists and central banks must deliberate on how best to manage these issues, and the secondary effects they bring with them, such as energy shortages and an increased cost of living. At the same time, businesses will continue to face market volatility and pressure on their supply chains.

Market trends

Following a period of retrenchment earlier in the year, the market has generally adopted a “business as usual” approach. This is partly because insurers are getting a more accurate view of how exposures related to the war in Ukraine have developed.

This indicates a new norm for market appetite and benchmark for pricing expectations. In particular, the increase in pricing is argued as a correction to more realistic levels, rather than a temporary reaction to current events.

As counterparties face tighter margins and supply chain issues continue to compound, insurers are showing an increased preference to support transactions for parties with deep, demonstrable business relationships.

Regarding sovereign risks, as pressure increases to balance the cost of living with increasing energy prices and a tough inflationary environment, insurers are preferring to support transactions that relate to key imports and government projects, assuming that adequate levels of foreign exchange (FX) supplies are available to protect cashflows.

One area that bucks the trend of retrenchment from insurers, is for deals that have a strong environment, social, governance (ESG) angle. For example, this could be a green project, or the trade of carbon credits. There is strong buy-in from management for these types of deals, which is well-received as demand for the product increases.

Underwriting strategy

Insurers in the credit & political risk insurance (CPRI) market continue to focus on key partner insureds and, in the case of credit risks, counterparties further up the credit curve.

The underwriting approach is based almost as much on the strength of the insured, as on the merits of the credit risk itself. Insurers want to partner with insureds who can illustrate a deep understanding of their counterparties’ business, and a willingness to help resolve issues that inevitably arise. The insurance product is to be seen as a port of last call, not the primary route of recovery in a default situation.

In order to consider writing a “weaker” transaction (i.e. approximately single B rated in the case of credit risks), it would need to benefit from a strong security package and in the case of government buyers/obligors, be of significant strategic importance to the host country.

Recommendations

While the above doesn’t paint a pretty picture, there are several ways for an insured to utilise the CPRI market successfully. To do so, they should focus on:

Quality submissions – a well-structured submission supported by detailed analysis will be viewed more favourably than one with little detail or sign of internal risk analysis.

Treat insurers as partners – insurers prefer to work with clients who adopt a portfolio approach to risk selection, using CPRI insurance to complement their business. Conversely, insurers are increasingly wary of the market being used to shift high-risk deals off a firm’s balance sheet (aka “risk dumping”).

Risk retention – a key to creating an alignment of interest with insurers is to be prepared to hold a fair retention of the risk. For more challenging transactions, many insurers will now offer a line equal to or less than the size of the uninsured participation.

Where CPRI adds value

As commodity prices volatility continues, insurance can be used to leverage a firm’s internal credit limits. Doing this allows the business to continue serving their end clients as demand for credit increases, without taking on levels of credit risk beyond internal appetite.

For further information, please contact the author under:

charles.purvis@lockton.com