Since the development of trade credit insurance in Dubai, the banking industry has tried to leverage trade credit insurance to secure working capital facilities offered to local businesses. From 2011 to 2015, many local banks offered invoice discounting facilities backed by a trade credit insurance contract to local SMEs.
Mitigation tool: Loss payee
The local practice between the banking industry and insurers has been to endorse the trade credit insurance policy to the bank through a contract endorsement called a ‘loss payee’ which is a tripartite agreement signed by the policyholder, the bank and the insurer. Basically, SMEs take out a trade credit insurance policy from one of the credit insurers available in the market and their insured account receivables are discounted by the banking industry.
As a consequence, lenders such as bankers are much more comfortable offering invoice discounting facilities to local businesses, considering that in case of non-payment of the invoice, the credit insurers will bear the loss.
Did this secure bankers sufficiently when the economic downturn showed up at the end of 2015 with its bunch of runaway cases?
The answer is: not as expected.
The reason is that a simple loss payee endorsement is not really workable as it does not offer sufficient guaranties for the lenders; it is no more than a risk mitigation tool.
In fact, this tripartite contract only gives to the lender the right to receive the indemnification of the claim, but the claim must be valid which is not the case all the time. For instance, one of the main reasons of a claim rejection is a late notification of the overdue which is a very important requirement of the contract. Indeed, policyholders are often reluctant to notify the overdue on time as they do not want to lose the credit limit guarantee and therefore the discounting facility they enjoy from the bank.
Alternative solution: co-insurance
An alternative solution for the bank is to be co-insured under the policy which gives the bank the right to notify the claim directly to the insurer without relying on the policyholder behaviour. Moreover, the bank is theoretically informed by the credit insurer if a credit limit on a particular buyer is withdrawn or if the policyholder does not comply with the contract
(i.e. late turnover notification or non-payment of insurance premium among other classical contract breaches). Otherwise, it is also possible to amend the loss payee wording to give more rights to the lender which can be equivalent to a co-insurance solution if it is done properly.
The above solutions, co-insurance or a customised loss payee, offer more security to the lender but it will never be as strong as insuring solely the bank.
Bank solely insured
In my view, insuring the lender directly against the risk of default of the borrower who is the client of the bank, is by far the best solution for the banking industry. Moreover, if the policy wording is written properly, it can be leveraged to optimise and reduce capital allocation under Basel 3 requirements (I will dedicate another article to this subject which is an important concern for bankers).
However, this solution differs from the two others as the underlying insured product is not the same; a financial transaction is insured rather than a commercial transaction.
How does it work?
The lender, which can be a bank or a private funder, offers a financing facility to a borrower, known as the obligor. Risk underwriters insure the amount of the facility offered by the lender to the borrower. Furthermore, the credit limit is non-cancellable which is essential for the lender as they are certain that the insurer cannot withdraw the guarantee during the course of the facility period.
In a trading hub, such as Dubai, traders are looking for more working capital to operate their businesses and increased financing facilities specifically to procure goods from suppliers located worldwide is key for them. Therefore, bankers can efficiently leverage trade credit insurance to increase pre-export finance facility offered to their clients, but the wording must be written properly and the insurance policy should be structured on a risk sharing basis between the two parties. Indeed, risk underwriters in emerging markets are ready to offer insurance capacity, but they want a 50% indemnification under the policy in order to be able to rely on the due diligence of the banker concerning the quality of the obligor.
Securing pre-export finance facilities with trade credit insurance is still under-developed in Dubai compared to other trading hubs such as London, Zurich, Singapore or Hong Kong. I am convinced that such trade credit insurance structures will represent a large share of the market in Dubai in the coming years.