A year after the UK Prudential Regulation Authority (PRA) published its controversial Consultation Paper (CP) 6/18 "Credit risk mitigation: Eligibility of guarantees as unfunded credit protection", the PRA has issued feedback and revised policy positions in a Policy Statement (PS 8/19) and an updated Supervisory Statement (17/13 "Credit Risk Mitigation") dealing with unfunded credit risk mitigation (CRM) for the purposes of calculating capital requirements under the Capital Requirements Regulation (575/2013) (CRR).

The new publications provide welcome policy revisions and the PRA has, notably, removed the proposed clarification to the meaning of "pay out in a timely manner", clarified its position on "legal effectiveness and enforceability" and introduced provisions around risks arising from eligible guarantee arrangements and recognising residual risks.

The new publications have allowed the finance and insurance industry to breathe a collective sigh of relief as some key issues arising from the previous proposals in the Consultation Paper have been addressed. The key positive development is that insurance, as a method of distributing risk and obtaining credit protection and the eligibility of credit insurance as an unfunded CRM has been clearly acknowledged by the PRA. Further, there is guidance for the industry generally on how to negotiate and use unfunded CRM more effectively to permit regulatory capital benefits. 

Meaning of “Pay Out in a Timely Manner” and Impact on the Concept of “Effective”

The PRA has removed its proposal that “pay out in a timely manner” means without delay and within days, but not weeks or months, of the date on which the obligor fails to make payment, and acknowledged that there could be difficulties in applying a single measure to different products which may be used as unfunded CRM in the form of "guarantees". However, the PRA has stated that the length of any "determinable" period, must not depend on circumstances which the firm has no influence over.

Matter of days < Pay Out in a Timely Manner < Determinable Period over which the Firm has no influence 

The PRA also specifically highlighted its concerns in respect of credit insurance as unfunded CRM where, due to a dispute between the insurer and the firm, the insurance had not paid out for long periods of time. The PRA expects that firms to consider risks arising from such unfunded CRM, including any residual risks, and have adequate risk management processes to control risks arising from the unfunded CRM. As such, the end-to-end operationalisation of how a firm complies with its contractual obligations under CRM will now be an issue that the PRA will look into as it has clearly stated that “Firms are required to have adequate risk management processes in place to control these risks.”

Additionally, with effect from 13 September 2019, firms will have to consider if a full substitution of risk weight under the Standardised Approach or probability of default under the Foundation Internal Rating Based approach is appropriate considering the effectiveness of the CRM and associated residual risks.

Legally Effective and Enforceable 

The PRA has also removed its proposal that the corresponding Article 194(1) CRR Opinion consider the practical ease of enforcement as well as the eligibility criteria for unfunded CRM in the form of guarantees under CRR. 

In doing so, the PRA has acknowledged that a legal opinion is not the only way to demonstrate such compliance, although it is one way of doing so. 

Exclusion Clauses

Insurance policies often have exclusions clauses, which are not directly addressed under Basel Accord principles or in CRR, and therefore there has been uncertainty as to the interaction with the concept of not including "a clause the fulfilment of which is outside the control of the firm". The PRA in the new publications has stated that nuclear exclusion clauses are not automatically contrary to CRR but rather may be contrary to CRR unless "in all circumstances" the provision "is immaterial" in respect of the exposure and the risk of obligor default. 

Further, the PRA also referred to other typical exclusions, such as obligor default due to a cyber-event or political or civil unrest and said they would likely be contrary to the requirement that the CRM does not include a clause the fulfilment of which is outside the control of the firm. In other words, for such other general exclusions, firms will need to consider whether such exclusion is within the insured’s control.

Clearly Defined and Incontrovertible

The PRA also expressed its concern of “broad or vague terms or obligations” which the firm must fulfil in order to obtain protection, and once again reiterated that the firms must consider the risk that the CRM provider “could in practice successfully seek to reduce or be released from liability under the guarantee”.   

Executive Summary

It would appear that the days of simple substitution of risk weights and probabilities of default for insurance as unfunded CRM are over and greater legal scrutiny in reviewing policies, attention to operational requirements and finesse in the valuation will be required. Understanding the risks arising from the underlying product and what risks are actually mitigated by the CRM and arise as residual risks will be required in addition to a very practical analysis of whether the firm, as a large organisation with different departments handling different aspects of the CRM, is actually able to comply with its obligations in the CRM.

Action Points

Review terms of insurance being used, or able to be used, as unfunded CRM that you have in place and consider:

  1. what are the timeframes for pay outs and what impediments are there to receiving the same?
  2. does the firm have policies and procedures in place to comply with the obligations in the CRM documentation?
  3. what risks are actually covered and what consequential residual risks arise?
  4. does the CRM have exclusion clauses and if so do these need to be renegotiated as the CRM may no longer be eligible as a CRM under CRR?

Consider your firm's broader approach to ensure your firm obtains the maximum benefit of CRM, including as to ensuring CRR compliance. 

If you have any questions, the authors advise insurers and insureds to negotiate policies, compliance with requirements for unfunded CRM (including in respect of bank-held and client-held policies) and governance to support distribution of risk on a portfolio basis.