In this third of our series of alerts, we focus on two broad areas of insurance: (1) credit risk (both structured and trade), and (2) political risk and violence. Read our previous articles on business interruption and event cancellation insurance on reedsmith.com.
Throughout the first quarter of 2020, we have witnessed COVID-19 spreading across the world at a dramatic speed. Its impact across all industries and businesses cannot be underestimated and, for many, the recovery will be slow. In a number of cases, there has been an effective shutdown of entire industries (including the aviation industry and the hospitality and tourism sector); others have suffered extensive supply chain issues and a wider stalling of production and service lines.
Some key questions that we explore in the first section of this article are:
For lenders and financial institutions: does any insurance you have in place provide an indemnity when your borrower defaults?
For businesses: does your trade credit risk policy cover missed payments by customers?
Structured credit risk (or non-payment) insurance
How structured credit risk works and what it covers
Structured credit risk insurance protects a financial institution (or lender) from defaults or other instances of non-performance on the part of their borrowers. This form of insurance is also commonly taken out by exporters, importers and manufacturers as it offers a means of mitigating cross-border payment risks. It is frequently used to support business growth in new geographic territories or in new lines of business in respect of which the risks of default may be greater.
By way of example, such a policy will indemnify an insured when a borrower fails to make a scheduled payment under a loan facility. Typically, the indemnity will be in respect of the principal sum only, and will not cover any interest or costs.
Generally, the loss (i.e. the unpaid principal sum) does not need to be caused by a specified insured event. This is of clear benefit to an insured as there is no need to demonstrate that the default was the consequence of a specific event, for example, a government order relating to COVID-19.
Unless, therefore, an express exclusion (or other policy terms restricting the cover) is triggered, we would expect a credit risk insurance policy to respond when borrowers default, regardless of whether such default was as a result of closures or other disruption caused by COVID-19.
The notification obligations and the consequences thereof will vary between policies, but some may require that insurers are informed of any relevant default within a relatively short period (such as 10 days) as a ‘condition precedent’ to cover. The policy may also enable pre-emptive notification of circumstances that may give rise to a loss under the policy. To avoid being in default of any notification obligations, we recommend that reporting lines are reviewed regularly and that training is provided as needed to ensure that relevant members of the organisation are aware of their responsibilities to notify potential claims. In current circumstances, traditional reporting structures may be varied (if staff become ill, or where staff are generally less connected) and it is important to ensure that key messages still reach the individuals responsible for the organisation’s credit risk protections.
A large number of central banks have pledged financial assistance to businesses to avoid or reduce the risk of defaults and insolvency. There is already some pressure on lenders to waive late payment clauses and provide flexible repayment options including payment holidays.
In its letter to lenders dated 26 March 2020, the Prudential Regulation Authority (PRA) urged financial institutions to carefully consider any breaches of covenants due to COVID-19. The expectation of the PRA is that lenders should consider waiving covenant breaches (with the understanding that it shall not automatically trigger a default of the Capital Requirements Regulation). If a lender is considering waiving a breach, the terms of its credit risk policy may require that insurer consent be obtained in advance (usually subject to consent not being unreasonably withheld). Given the recent communication from the PRA, it may prove difficult for insurers to refuse or withhold their consent.
A credit risk insurance policy will also often include an obligation on an insured to mitigate its loss, whether by issuing a claim against a borrower or by seeking to recover under any guarantees provided by companies in the borrower’s group. These duties will vary considerably between policies, and we recommend that the policy wording is reviewed carefully.
In this unprecedented and continually changing landscape, financial institutions will be closely monitoring regulatory guidance from the PRA and Financial Conduct Authority (FCA), along with statements from the government and the Bank of England. This guidance should be considered carefully in conjunction with the terms of any credit risk policy in place to ensure that cover for any payment default is provided as expected.
Renewal considerations
While many structured credit risk policies offer long-term protection and do not necessarily renew annually, if the policy is due for renewal in 2020, there are some points worth considering in advance, so that internal stakeholders can be prepared for questions from insurers about the risk to be insured. The scope of the cover and any new exclusions should be carefully considered.
- Notwithstanding the coronavirus crisis, 2020 had a turbulent start (including U.S.-Iran relations and the collapse in oil prices), which has affected credit quality more generally. This may impact premiums going forward.
- Capacity in some sectors that have particularly suffered as a consequence of COVID-19, such as aviation and hospitality, may be reduced.
- Credit risk policies are based on a borrower’s credit risk, and we expect insurers will ask questions on renewal about a borrower’s current and future risk of exposure to COVID-19, or pandemics in general.
- Backward-looking financials from 2020 may (wrongly) indicate a borrower’s poor performance, so these should be provided in conjunction with forward-looking projections to avoid giving a distorted view of the risk.
Financial institutions may, in particular, wish to “de-risk” their balance sheets following defaults as a consequence of COVID-19. Given the anticipated losses by industries and the insurance market, it is worth entering into discussions with your broker and insurers well in advance of any renewal or lending deadlines.
Trade credit insurance
How trade credit insurance works and what it covers
Disruption to trade was one of the very first and immediate impacts of the coronavirus outbreak, and such disruption has affected a huge range of industries, from the chemical and textile industries to automotive and electronic sectors. As COVID-19 has spread globally, the declining revenue and cash flow of businesses, along with the potential impact of parties calling force majeure on trade contracts, has increased the pressure on businesses, resulting in a knock-on effect on trade credit risk insurers.1
Trade credit insurance typically provides comprehensive credit coverage for non-payment of eligible account receivables (usually subject to certain express exclusions). Trade credit insurance is similar in some ways to bad debt protection products, which are a type of recourse factoring and may be offered by financial institutions in connection with a loan facility. Some trade credit policies for businesses operating in certain jurisdictions may also include a political risk endorsement. We discuss political risk policies in more general terms below.
The two common triggers for an indemnity under a commercial trade credit risk policy are (1) customer insolvency, and (2) default due to customer cash flow issues.
As with structured credit risk insurance policies, there is generally no requirement for an investigation into the underlying cause of the customer’s insolvency or non-payment, provided it is not expressly excluded.
The extent of the cover afforded by any particular policy will depend on the risk, insurer appetite and the level of premium.
When presenting a claim under a trade credit policy, its terms will usually require the insured to demonstrate that they have exercised due care and diligence to avoid or reduce the debt. In relation to the impact of COVID-19 on trade, due diligence is likely to include reviewing existing contracts carefully to ensure obligations are honoured or mitigated where possible; and exercising caution when exporting into certain jurisdictions (including considering whether doing so will mean that the loss is foreseeable, such as exporting into jurisdictions severely affected by COVID-19).
Provided that an insured has acted within the policy terms and conditions, including exercising the required due diligence, credit risk policies should respond to losses relating to insolvency or default of customers due to COVID-19.
Renewal considerations
The global economic decline as a result of COVID-19 may mean that insurers will seek to reduce capacity in this area, particularly in certain jurisdictions.
It would be prudent to plan for any renewals well in advance. This includes working with your broker so that insurers are well-informed and comfortable with financial projections, planning and exposure. Careful and proper preparation in the presentation of the risk will be key to favourable terms of renewal.
Political risk and violence policies
Insurance for political risk and violence is typically associated with all risks property or hull and machinery insurance policies. These property policies typically have an express exclusion for war and political risk. However, ‘write back cover’ can be obtained by way of an endorsement and payment of an additional premium.
Standalone political risk and violence polices can also be purchased to cover a range of perils, including war, civil unrest, terrorism and government expropriation. Policies are often bespoke and tailored to the specific risks where the business has exposure.
In general terms, a political risk and violence policy will indemnify an insured for losses suffered as a consequence of a specified Insured peril. A policy can provide compensation for both physical damage to property and loss of attraction/reduction in turnover.
Based on the current circumstances, political risk policies are not the natural candidate for cover of any losses stemming from COVID-19. However, as always, it is key to check policy wording and endorsements carefully. We set out below some of the key coverage points that should be considered if you have political risk cover.
1. Insured Peril
A pre-requisite for cover under a political risk and violence policy is that there is an insured peril or a covered event. These will vary between policies, but typically include war, invasion, revolution, terrorism and civil unrest. Increasingly, we are seeing debates on whether COVID-19 falls within the scope of an insured peril. The language in the media of “fighting a war” combined with the use of wartime powers by national governments, gives the impression of a world under attack. However, for the purposes of cover under a political risk policy, insurers are likely to view such proposals with scepticism.
The insured perils covered by a particular policy are often specifically defined within the policy wording. Failing that, guidance may be found by reference to the overall context within the policy. It is worth noting that, as a matter of English law, policy language will be given its natural and ordinary meaning and terms will be construed in their overall context. Traditionally, when the English courts have been asked to consider policy terms including “war” and “hostile acts”, it has drawn connotations with belligerent acts of enemies.2
In the absence of any specific reference to viruses or pandemics, COVID-19 is unlikely to qualify as an insured peril, as defined by the policy.
To date, action taken by national governments is unlikely to amount to an insured peril. In the absence of government policies being draconian or arbitrary, or discriminatorily targeting specific industries, it is difficult to see traditional political risk and violence policies being triggered at this stage.
2. Physical damage
A further consideration is the requirement for the insured peril to cause “physical damage” to the property insured, in order to trigger coverage. Some early notifications to property policies have sought to advance a claim that COVID-19 causes damage to door handles and surfaces, which has restricted access and meant that the property cannot be used for its intended purpose. We anticipate that Insurers will seek to resist claims of this nature as being outside of the ordinary concept of “physical damage”.
Cover might be found in a “non-damage” extension, if applicable. Some non-damage extensions have a trigger based on mandatory closure by a competent authority, which could encompass closures ordered to reduce the spread of COVID-19. To date, insurers have not publicly taken a position on policy liability under this extension. However, we would expect insurers to raise exclusions, such as an “all other circumstances” exclusion, along with causation arguments to reduce their exposure. These non-damage extensions are also often sub-limited so an insured may not necessarily recover the entirety of their loss.
3. Loss of attraction/business interruption - causation
In the current COVID-19 crisis, any indemnity for a reduction in turnover will be paramount for businesses. Some, but not all, policies provide an indemnity for loss of attraction (i.e. a reduction in turnover). Generally, policies will require that the loss suffered is the sole and direct result of the insured peril. As with any business interruption claim, the difficulty for the insured lies in proving that the losses suffered are solely as a result of a covered event. For example, the insured must prove that the reduction or loss of turnover was a result of COVID-19 and not as a consequence of reduction in footfall, a change in consumer habits or another excluded event.
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Going forward, we expect insurers to seek to remove ambiguity as to whether the consequences of COVID-19, or other pandemics, are covered by political risk and violence policies. We may see insurers adding express exclusions on renewal to avoid uncertainty. If specific pandemic cover is required by an insured, this may be offered but for an additional premium.
On 15 April 2020, the FCA wrote to insurers asking them to pay out claims related to COVID-19 as soon as possible. In a “Dear CEO” letter to the insurance industry, Christopher Woolard, interim CEO of the FCA, indicated that for policies where it is clear that the insurer has an obligation to pay out, claims must be assessed and settled quickly.
If you are concerned that insurers are delaying your claim, or would like further advice on policy review and potential coverage, or assistance with making a notification under any of your policies governed by English Law, please do not hesitate to contact the London Insurance Recovery team at Reed Smith.
Our Reed Smith Coronavirus team includes multidisciplinary lawyers from Asia, EME and the United States who stand ready to advise you on the issues above or others you may face related to COVID-19.
For more information on the legal and business implications of COVID-19, visit the Reed Smith Coronavirus (COVID-19) Resource Center or contact us at COVID-19@reedsmith.com.
- If a party has called force majeure (correctly or incorrectly), this may affect the available cover. For our alerts on force majeure in the context of COVID-19, please reedsmith.com.
- Britain S.S. Co. v. The King (The Petersham) [1921] 1 A.C. 99; and Clan Line Steamers Ltd v. Liverpool and London War Risks Association Ltd [1943] K.B. 209.
Client Alert 2020-264
