Vol 1 (2004) - Issue 6

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Credit Insurance - Valuable Protection? The Legal Issues Arising

Introduction

Credit protection is widely used as a risk management tool in the financial markets. Financial Institutions buy and sell protection. Whether the protection is provided by a credit derivative or credit insurance, the objective is the same - to hedge the purchaser’s credit exposure to a particular counterparty in the event of a credit loss brought about by that counterparty’s insolvency or financial distress. In this article we address three central questions: what is credit insurance? what protection does it bring with it? How is it used in the market today?

What is credit insurance?

A straightforward question with a straightforward answer, surely? The reality is that a distinction has to be made between ‘traditional’ insurance policies issued by regular multi-line insurers and ‘financial guarantee’ insurance policies, which are issued by the mono-line bond insurers operating under monocline licences.
‘Traditional’ insurance will carry with it the right on the part of the insurer to analyse the validity of the claim, adjust it and, if justified under the terms of the policy, to dispute the validity of any claim. This approach is common in the world of multi-line insurance. Even when a policy, on the face of it, covers the insured risk, the uncertainty caused by this approach by insurers means that the protection afforded by ‘traditional’ insurance is not sufficient for certain types of financial transaction. This applies particularly in the structured finance world where certainty of credit enhancement may be required.
Let us reflect for a moment on the difference between a guarantee and an indemnity which would be offered by the ‘traditional’ insurance route. Whilst a guarantee has certain inherent weaknesses, e.g. the courts’ protective stance in relation to guarantors and the ability of the guarantor to stand or fall by the validity of the underlying guaranteed obligation, nevertheless they afford a degree of predictability on enforcement which is highly desirable in many financial transactions. The evidence over mercantile history in developed jurisdictions indicates that guarantees, or, for that matter, standby letters of credit, issued by financial institutions are regarded as the lifeblood of commerce and finance in providing that certainty and confidence in outcomes. Those features in today’s commercial world are absolute necessities for credit enhancement in the financial marketplace and so will contain:

- an unconditional obligation to pay;
- an unequivocal and straightforward method for the submission and payment of claims;
- an unequivocal and unconditional waiver of any and all rights and defences to payment available to the insurer under common law or equity, including set-off, counter-claim, fraud (other than fraud undertaken by the beneficiary in submitting the claim) misrepresentation, or breach of covenants by the insured party.

What protection does it bring?

Contrast these features with a ‘traditional’ insurance contract. A contract of insurance is a contract of indemnity governed by the uberrimae fidei rule: in other words, it is a contract of utmost good faith and this means that a policy may be avoided for concealment/ non-disclosure in relation to matters material to the risk insured where this has been done in bad faith. Apart from terms implied in a contract of insurance, there will be many express contractual terms regulating the contractual relationship between insurer and insured. Examples of representations and warranties which the insured may have to give to the insurer in a credit insurance contract are:

- no knowledge of any circumstance which could give rise to or increase the likelihood of a loss;
- information supplied by insured to insurer in connection with the application for insurance is