Non-payment insurance for banks
Insurance by which a bank transfers to the insurance market part of the default risk on its loans and trade finance, to reduce its exposure and, if eligible, its capital requirement.
Non-payment insurance covers a bank against a borrower's failure to pay on a loan, a letter of credit, a prefinancing or any trade finance facility. It differs from classic trade credit insurance, which protects a supplier against its customers, in its insured, a financial institution, and in its logic, which is credit risk transfer. The private credit and political risk market, largely based in London, is its main provider, and structures often also cover political causes of default. The bank gains three things: reducing its concentration on a borrower or country, freeing internal limits for new business, and, when the policy meets the conditions of bank prudential rules, obtaining a reduction in its capital requirement by substituting the risk of a well-rated insurer for that of the borrower. That last condition requires strict wording: unconditional payment within a defined period, limited exclusions, no unilateral cancellation right. For the insurer, the difficulty is information asymmetry, since the bank knows the borrower far better and chooses what it insures.
Textbook case: a bank grants a 100 million dollar prefinancing to a commodity trader and insures 50 percent of the risk with three A-rated insurers. If the policy meets the prudential criteria, the bank weights that half at the insurers' risk rather than the trader's, which significantly reduces the capital it must hold.
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