Hidden within the thousands of pages of rules that make up the latest version of the Basel banking regulations is a provision that is causing consternation in the credit insurance market.
A proposal by the influential Basel Committee, already accepted by the UK, would significantly reduce the benefits of credit insurance for some large banks. Jacob Atkins breaks down what has happened so far and what the impact may be.
How do banks currently use credit insurance?
Credit insurance is widely used across the trade, supply chain and commodity finance markets to add an extra layer of risk protection to transactions. Banks, non-banks and even corporates take out policies that mean, in theory, that if a trading counterparty or a borrower fails to pay for goods, or defaults on a loan, the insurer can step in and cover the loss.
But the product also has another important use case for large banks, particularly in Europe and Asia: it helps reduce the amount of capital they need to hold in reserve, freeing it up for more productive uses such as lending. In fact, according to an industry survey, this is the second-most popular use case of credit insurance for banks.
Under the current (soon-to-be previous) Basel framework, some banks – typically large ones – have been allowed to use the “advanced approach” to calculate their capital requirements. Simply put, this method allows banks to create their own internal models to estimate the probability of default for various types of obligors and, in the event of default, to determine what percentage of that exposure was likely to be a loss. This is called the loss given default (LGD).
Until now, banks have been able to create and use internal models to calculate the LGDs for insurers. They could then take out credit insurance on an exposure – a trade loan, for example – and use the lower LGD of the insurance provider instead of the higher LGD of the borrower to significantly reduce the capital requirements applicable to the loan.
Is Basel 3.1 changing that?
The Basel Committee – the highly influential group of central bankers and regulators that drafts the framework – had become dubious about the quality and consistency of banks’ modelling, and the overwhelming thrust of the Basel 3.1 reforms has been to severely limit banks’ use of the advanced approach.
As part of that, Basel 3.1 removes the option for banks to model their own LGDs for credit insurance exposures and applies a 45% LGD. That change means credit insurance policies will no longer provide substantial capital relief because LGDs for corporates will generally be lower than for insurers, although some other changes will still allow some relief.
Banking regulators and governments in each country can choose how to apply the framework. For example, the EU has decided to go off the Basel script and spurn the committee’s suggested stricter capital treatment of off-balance sheet trade finance instruments. But generally, they try to hew closely to the framework to ensure worldwide alignment.
What have regulators in the UK decided?
In the UK, the Bank of England’s Prudential Regulation Authority (PRA) said in September that the country will stick to the Basel Committee’s recommendations.
This means that from January 1, 2026, all banks in the UK using the advanced approach must apply a 45% LGD on insurance policies, including credit insurance. The PRA said at the time it made the call because “it shares the Basel Committee on Banking Supervision’s concerns regarding the robustness of LGD… models for exposures to financial corporates”.
Banking and insurance industry groups had argued fiercely for the PRA not to simply transplant what they see as the Basel Committee’s overly conservative approach. They have instead said a minimum LGD of 20% for credit insurance more accurately reflects the likely loss if an insurer defaults, noting policyholders’ hierarchy in the ranking of creditors. But the PRA said it “was not persuaded by respondents’ arguments for a lower […] LGD given the lack of evidence that losses on exposures protected by credit insurance justify a LGD below 45%”.
The PRA pointed out a conundrum that was also singled out a few weeks later by the European regulator: there is very little data for banks to model defaults for insurers because, in recent years, there haven’t been any defaults. While the insurance industry believes that should instil confidence in the stability of EU insurers, which are subject to strict regulation of their own, the Basel Committee, PRA and European Banking Authority (EBA) believe the lack of data means banks cannot “robustly” develop reliable LGD estimates.
What about in the EU?
In the EU, no final decision on an LGD has been made yet. While Basel 3.1 implementation (referred to as Basel 4 in the EU) is largely finalised, the European Commission had previously asked the EBA to write a report on the “eligibility and use of credit insurance” as a credit risk mitigation technique, which the Commission indicated it would use to produce a legislative proposal.
After missing its initial June deadline, the EBA published its report in September. It said that analysis of the “theoretical framework” and available data for credit insurers are “not sufficient to warrant a deviation” from Basel. Like the PRA, the EBA noted that “no credit insurer in the EU has defaulted so far”, making the task of estimating LGD for credit insurers a largely theoretical exercise for banks. In essence, the EBA – previously critical of EU law-making bodies for deviating from the Basel text – found that credit insurance should be treated similarly to other credit protection products, such as guarantees, and does not warrant any favourable regulatory treatment.
The EBA report “wasn’t as damaging as it could have been” because the regulator acknowledged that credit insurance is an important risk mitigation tool for banks, says ING’s Jean-Maurice Elkouby, speaking as a member of the International Trade and Forfaiting Association (ITFA) insurance committee.
But he says he was disappointed the EBA didn’t deem credit insurance to be a cut above other techniques, such as guarantees, because, in his view, insurers are an even safer bet than the banks that typically provide guarantees because they are heavily regulated and unlike banks cannot suffer a sudden withdrawal in capital. “The CPRI [credit and political risk insurance] market, as we know it, will suffer from this, that’s a fact,” he tells GTR.
The insurance and banking sectors now intend to switch focus to persuading the Commission and EU lawmakers to diverge from the EBA and allow banks to apply a lower LGD, ideally 20%.
“Everybody’s looking at the content of the EBA report, but actually the impact of that report isn’t clear until the European Commission determine what it is or isn’t going to do about it,” says a CPRI broker who requested anonymity.
It is unclear when the Commission will respond to the report. A Commission spokesperson tells GTR: “We have received the report and we will assess it in detail.”
Which banks will be most affected?
Most banks using internal models to assess credit risk are large, sophisticated lenders, while smaller banks predominantly use the standardised, or “foundation”, approach. Under this framework, a fixed 45% LGD is already applied to insurance exposures. In a telling sign of the possible market impact of that LGD, those banks do not typically use large amounts of credit insurance.
Market sources say the biggest buyers of credit insurance in Europe are the top French lenders, such as Société Générale, BNP Paribas and Crédit Agricole, all of which declined interview requests for this article. Lenders in other wealthy northern European economies such as Belgium, the Netherlands and Scandinavia are also said to be major credit insurance customers.
Large lenders currently creating their own models “will see a big impact in terms of the benefit that they get from using credit risk insurance, given the LGD change”, says a UK-based broker. But they add the changes won’t affect other banks that weren’t applying significantly lower LGDs in the first place, or were using the standardised approach.
How badly large banks are affected will hinge on the LGDs they are currently applying to credit insurers. This is not something banks publicly disclose, or make a habit of telling their insurers about, but sources suggest that LGDs of 20-30% are not uncommon, meaning some banks will see the capital relief they were previously getting from using credit insurance cut drastically.
Elkouby says “there’s a wide range” of LGDs being applied. “I know some banks were more aggressive than others, and some banks would struggle with a jump to 45%.”
Will banks buy less insurance?
Inevitably, yes. As Elkouby points out, insuring what he calls “more vanilla, better risk” exposures will no longer provide meaningful regulatory capital reductions. Insurance will still work for higher-risk exposures, because despite the higher capital requirements for credit insurance, an exposure to an insurer will usually still be better than unmitigated exposure to low or unrated corporate exposures.
But in a 45% LGD scenario, it will be less effective for banks to use credit insurance on lending to well-rated corporates, because the gap between the capital requirements for those corporates and the previously more favourable capital requirements for insurers will shrink.
Referring to that loss of benefit, Santander’s head of private debt mobilisation for Europe, Silja Calac, said during a September event organised by software provider Schumann: “For me as a bank, it will not work anymore… this will have an impact on my buying of insurance.”
Yet insurers and bankers say there may also be some upsides for the credit insurance industry. Insurers and brokers in Europe say they expect higher capital requirements across the broader Basel 3.1 package may prod banks into buying insurance for types of lending they aren’t currently using it for.
According to Calac, the jump in assets that banks will need to hold capital against “is good news for the co-operation between banks and insurers, because we will need more insurance” to help offset the regulatory capital burden.
What do insurers say?
Credit insurance products form only a small part of the business of most large, diversified insurers. On average, the product line represents less than 2% of overall gross written premium at multi-line insurers, according to an ITFA survey cited in the group’s submission to the PRA, which also put the credit insurance premiums paid to Lloyd’s of London over the last 10 years at £6bn. However, there are more specialised CPRI insurers and brokers for which the market is more material.
Insurers and brokers who spoke to GTR acknowledged that a 45% LGD is going to be a blow to the market, but were largely confident the market would be able to absorb it. The fight against implementing the measure in the EU is also far from over, with some hoping that EU lawmaking bodies can be talked out of adopting the EBA’s position.
Despite the expectation that rising capital requirements across the board could whet banks’ appetite for applying credit insurance to other exposures, there is widespread worry that, as credit insurance for low-risk exposures becomes less economical, banks may only pass on lower-quality, higher-risk assets to insurers. While higher-risk exposures are already part of the insured portfolio, insurers have typically accepted them in part because they are balanced by well-rated, more straightforward risks.
As Carol Searle, general counsel of broker Texel, put it during the Schumann event: “If we find ourselves in a position where only the worst-rated risks are going to be brought to the insurance market, there is a concern that that will ultimately end up reducing the capacity of the insurance market to ensure this type of risk, so there’ll be less insurance available in the long term.”
Another broker tells GTR that while “the ability to continue to purchase the same portfolio profile as you are currently doing will not be there”, it doesn’t mean “you can’t expand the product into areas that previously were maybe under-utilised”.
Even if the supply of well-rated corporate exposures slows, many insurers are well-equipped to analyse the types of deals expected to form a larger share of banks’ credit insurance needs in a post-Basel 3.1 era – namely, lending to high credit quality companies that may not have third-party ratings.
“I think insurers do have the sophistication to make their own credit assessments without the requirement for external ratings,” says another senior broker. “If there’s benefit there, the insurers will still look to support businesses with a good credit strength, but they don’t necessarily need external ratings in order to do that. They can make their own assessment.”
