Can you give a little detail on your background and experience in this area?
I started my career as a corporate finance lawyer advising clients on a range of capital markets, mergers and acquisitions, and structured finance transactions. After a number of years as a lawyer, I moved across to the insurance industry as an underwriter, leading a niche team that focused on structuring and underwriting insurance solutions for specialist financial risks. We worked with a range of institutions, including banks and asset managers to provide insurance solutions for risk mitigation, regulatory capital and balance sheet management purposes. The solutions we underwrote included covering securities lending indemnification.
I recently joined Texel Finance, a specialist insurance broker for financial risks in order to grow the market, both among clients and the insurance market for the types of cover that I previously underwrote, including securities lending cover.
How can insurance be used in the context of securities lending indemnification?
Insurance in this context can be used to provide protection against the default of a borrower or repo counterparty—usually in connection with an insolvency event. Exactly how the insurance is used and structured depends on the needs of the insured.
In the simplest structure, an insurance policy is used to indemnify an agent lender against loss they suffer because of a borrower defaulting on a lending or repo transaction. The agent still provides an indemnity to their client but the insurance policy effectively acts as a backstop or counter-indemnity should the agent’s indemnification of the client be called if a borrower or counterparty defaults. Cover can be provided by large well-rated insurance companies and so this structure is attractive where the agent doesn’t have the balance sheet to efficiently support the indemnity or when the agent’s clients want an extra layer of ‘sleep easy’ protection.
I’ve also explored using insurance to completely replace the indemnity provided by the agent in respect of borrower defaults. This structure can be logistically and contractually more complicated but has the benefit of completely removing the indemnity for an agent lender, which can help from a balance sheet and regulatory capital perspective. That said, this is something I know is being looked at both by lenders (for their own account) as well as agents.
So can insurance effectively be used to replace the agent lender indemnity?
It depends on the terms of the indemnity you want to replace. If the indemnity is a blanket indemnity, which promises to make the client whole for any loss arising for any reason whatsoever, then that will obviously be a challenge.
However, if a client wants to replace an indemnity and the primary value of the indemnity is in the protection it provides against counterparty default, then insurance can certainly be a replacement solution.
Can you elaborate on what the terms of a typical insurance policy look like in this space?
This isn’t an ‘off the shelf’ product so policies are typically bespoke, being tailored according to the client’s needs as well as the requirements of the insurers.
In general terms however, every insurance policy will clearly define the nature and scope of the loss to be covered and include provisions setting out how that loss is to be calculated—these provisions may mirror the standard terms of the underlying trade documents to avoid any basis risk.
The policy will also specify those borrowers and counterparties whose default is to be covered by the insurer and may include a mechanism for adding new counterparty exposures to the cover on an ongoing basis.
A key source of comfort for insurers underwriting the risk will be the risk management practices and track record of the client, so the policy will usually include some representations and undertakings to ensure that key risk management practices continue to be observed. It should be noted, however, that these will be drafted to avoid interfering with or imposing any burden on how the client runs their business—in fact how clients run their business and manage their portfolios can play a big part in getting insurers comfortable with the risk.
The policy will also include a list of exclusions setting out matters excluded from cover. These are usually reasonable and within the controlled of the insured and may, for example, exclude loss arising from a material breach of the underlying lending or repo documents by the insured.
Other key terms are the limit of liability and the tenor of the policy. These can vary depending on the client’s needs.
Limits are typically sized by reference to the typical exposure values of the positions in a programme.
Policy tenors can range from a rolling 12 month period up to 3 years. Longer tenors may be possible but will very much depend on the particular fact pattern in question.
How much does this insurance typically cost?
Premiums for such policies are usually calculated as a percentage of the limit of liability and can range from around 1 percent to 2.5 percent per annum. The actual amount depends a lot on the credit quality of the counterparties to be covered and other policy terms.
Are there any typical hurdles or challenges you’ve encountered with using insurance in this space?
While securities lending indemnification exposure is covered in the insurance market and there is a growing market appetite for new forms of credit exposure, securities lending indemnification cover is still considered somewhat specialist. It’s therefore important to work with parties who are familiar with this sector and who can articulate the risk to the insurance market.
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