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Debunking the myth that mark-to-market credit exposure is uninsurable.

Over the past two decades, most credit and political risk insurers have really struggled with the concept of underwriting exposures considered to be financial risks versus those viewed as traditional "trade credit" risks. However, in recent years, a few smart and innovative insurers have grasped that some so-called financial risks represent a great growth opportunity for the industry.

Historically, insurers have categorized these two concepts based upon whether the credit exposure was incurred in the normal course of trade or as a result of commodity price swings that rendered certain contracts underwater or "out-of-the-money" (as one "financial" risk example).

In the latter case, this type of financial risk is more commonly referred to as mark-to-market risk. Think of energy commodity suppliers that enter into longer term, fixed-priced contracts with their customers. Those suppliers can be susceptible to very large credit exposures in the event that the underlying commodity's price falls below the contract's original fixed price. Quantifying (and mitigating) that type of credit risk is very challenging at every point in the life of the contract. This becomes especially apparent when the energy supplier's customer becomes insolvent because the customer may be able to get many of its pre-bankruptcy contractual obligations annulled. Cheaper prevailing market costs may incent the customer ("debtor") to do this. Now the energy supplier is in the unenviable position of still having to fulfill its own existing contractual commitments with its own suppliers and simultaneously replace that lost revenue and commodity delivery volume with new or different customers at much lower prevailing market prices as the debtor has been absolved of its pre-bankruptcy obligations. That differential between the supplier's cost and total value of the remaining contract with the insolvent customer at prevailing market prices represents the supplier's mark-to-market risk.

Though this type of credit risk has existed for as long as commodities have been purchased and delivered, it was only within the last decade that one could obtain this coverage, and only on a very select and limited basis. Now there are several underwriters willing to write this. For those that still won't participate in the market, the reasons range from:

* Not understanding the risk or how to quantify it.

* A view that this type of credit exposure is not a true accounts receivable generated in the normal course of trade (i.e., buying and selling of goods and services).

* Concern that this coverage might be outside of its reinsurance treaty or regulatory charter.

The good news for large wholesale and retail commodity suppliers is that there are now a handful of savvy credit insurance underwriters out there that, with the support of their reinsurers, have been able to see those old school arguments as economically irrational and sometimes patently nonsensical. Under the U.S. Bankruptcy Code, if a debtor chooses to reject any of its "Executory Contracts" (i.e., its pre-bankruptcy obligations such as equipment leases, real estate leases or other longer term fixed-cost contracts), and the court upholds those rejections, there is a formulaic guideline for determining the damages to the creditors. When and if those damages become "allowed" by court order or stipulation, that "allowed claim" is pari passu to the claims of every other unsecured trade creditor. In the end, U.S. laws treat the claims of those suppliers who sold pens, staples and paper clips to the Debtor exactly the same way as the allowed, general unsecured claims of an energy supplier whose own claims may consist of: (a) an accounts receivable generated by the physical delivery of a commodity; and/or (b) the financial damages associated with the debtor's abrogation of a long-term fixed-price contract.

Assuming that the credit insurance underwriter's reinsurance treaty allows it, then the insurer's fundamental concerns should focus on:

* Does the insurer have the appetite and capacity for most, if not all, of the suppliers credit exposure, regardless of its origin?

* If so, can the insurer receive a premium that is commensurate with the unsecured credit risk? Since many mark-to-market exposures can run well into eight and nine figures, this concept of appropriately priced risk is vital.

* If the requested coverage limit is too high, is there sufficient capacity available amongst potential partners in the syndication market?

* Is the policyholder willing to purchase this coverage on an insolvency-only basis? This is mandatory because broad-based nonpayment perils such as protracted default and failure to pay are not feasible for mark-to-market coverage.

As more insurers continue to enter the North American market for trade credit and political risk, it's become more important than ever that all carriers, both new entrants and those already well established, find ways to differentiate themselves from one another. Although the number of underwriters in North America, especially the United States, has grown tremendously in the last two decades (from approximately six in 1996 to more than 15 now in 2016), providing much new needed capacity in the process, it's also had a significant premium softening effect on the U.S. marketplace with a material lowering of credit underwriting standards. The effects of this weak pricing and loose underwriting will become quickly apparent in the next economic downturn. Product differentiation and innovation is the key to pricing power in a highly competitive, credit-driven industry, particularly in such a lower interest rate environment. Therefore, suppliers and insurers alike will do well to keep their minds and ears open as credit risk mitigation tools continue to evolve and become more sophisticated.

Marc Wagman is area executive vice president at Arthur J. Gallagher & Co. Before joining the firm in February 2015, Marc served as managing partner at AEQUUS Trade Credit for 11 years and a sales executive for Euler Hermes in New York focusing on middle market business development. In the early 1990s, Marc sourced trade claims and sold receivable puts for Avenue Capital, a New York City-based hedge fund. He can be reached at
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Title Annotation:SELECTED TOPIC
Author:Wagman, Marc
Publication:Business Credit
Date:Nov 1, 2016
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