COVID-19’s impact on Credit & Surety Bond and counter measures
- Predictions of a tsunami of claims triggered by COVID-19 failed to materialize mainly due to strong government interventions coupled with adjustments in product features and swift risk management by insurance companies.
- While bankruptcies were averted, a confluence of factors is working on releasing the floodgate, which could herald in more insolvencies in 2022/2023.
- A high level of uncertainty still prevails. Some government supports are fading out whilst recent events including heightened geopolitical tensions, rising inflation and interest rates are all clouding the market’s outlook, and require underwriters to maintain a cautious underwriting approach.
Introduction
Following the onset of the COVID-19 pandemic, the global economy plunged headlong into a deep, though relatively brief, recession in early 2020. The highly contagious SARS-CoV-2 virus has resulted in widespread lockdowns worldwide, disrupting production and logistics. Consumer demand also fell sharply. As the emergence of new variants drove subsequent waves of infections at a time, the world rushed to produce enough vaccines for its more than 6 billion inhabitants. Estimates suggested a loss of economic output of around USD10 trillion over 2020-21.[1]
From the perspective of credit & surety underwriting, one of the striking features over the past two and a half years was the relatively timid insolvency trend, despite the challenging macroeconomic headwinds. In early 2020, the Bank for International Settlements suggested that up to half of the firms could face cash shortages during the first year of the pandemic. A survey of 30,000 small business leaders across 50 countries reported reduced sales and closure of over 25%.[2] Using historical data, it was estimated that the size of the economic shock we saw in 2020 would result in a 40% increase in global insolvencies. What transpired is the opposite, with insolvencies dropping by an estimated 12% since 2020.[3] What are the reasons for defaults defying the economic cycles, and what does this mean for the outlook of the global credit and surety insurance market?
Government supports for credit & surety insurance
A key factor that differentiates this round of economic turmoil from previous ones, such as the 2009 Global Financial Crisis, is the strong support offered by governments to cushion the negative impact of the pandemic. Following the outbreak of the epidemic, governments of major economies launched various schemes to protect jobs, safeguard supply chains and bolster domestic consumption. In external trade, governments have put in place schemes to offer credit insurance to maintain the flow of trade (see Table 1).
Table 1: Examples of government policies to support credit insurance during the pandemic
Source: COVID-19 situation update, Week ending 29 May 2020, Aon
Through the Trade Credit Reinsurance Scheme launched in May 2020, the British government offered up to GBP 10 billion reinsurance capacity to credit insurers operating in the UK.[4] In Germany, government support was offered to all credit insurance companies through risk sharing between the insurers and the State up to EUR 50 billion, with an additional layer of cover up to EUR 30 billion in total if required. In France, the government provides EUR 12 billion of support through proportional reinsurance to bolster the underwriting capacity of French credit insurers. Likewise, the Belgium government provided a EUR 903 million reinsurance plan to support trade credit insurance, based on the Temporary Framework approved by the European Commission.[5] Other markets, like Canada, Netherlands, New Zealand, and Turkey, have also launched pilot schemes to explore ways to support credit insurance.
Indeed, a World Bank study showed that governments had reacted more swiftly during the COVID-19 pandemic than in previous crises. Substantial fiscal stimulus was offered – around USD 9 trillion – by May 2020. Furthermore, in over 80% of the economies surveyed by the Bank, some forms of debt repayment emergency measures were implemented. Apart from support for credit insurance schemes, other actions taken include prohibiting the acceleration of contractual terms, eliminating interests and penalties, or banning the repossession of property. Less common is the suspension of judicial proceedings measures, which were only taken up by around one-quarter of the studied jurisdictions.[6] While many of these measures could be focused on certain subjects or sectors and came with specific timeframes, they nonetheless have afforded firms much-needed breathing space and soothed the insolvency trend.
Economic drivers of insolvency and delinquency
So, are economic cycles alone no longer predictive of insolvency?
To begin with, GDP volatility has increased over the past years. Following a sharp recession in the early months of 2020, the global economy staged a strong rebound in 2021. However, the onset of more virus variants and the outbreak of war in Ukraine saw growth drop again in early 2022, alongside rising concerns about inflation. For instance, the US reported two consecutive quarters of negative GDP in the first half of 2022. This heightened economic volatility makes disentangling the relation between GDP growth and insolvency that much harder, particularly since insolvency lags the economic cycles, sometimes by over a year or two.
Nonetheless, we believe that insolvencies are firmly grounded on economic cycles, but government actions could prolong the gestation period. Some policies including those that aim at bolstering economic growth or domestic consumption, will help to forestall insolvencies. On the other hand, administrative measures to disrupt bankruptcy proceedings could only delay, rather than reverse, the onset of insolvencies. When measures to support firms and stall insolvency expired in 2021 in some markets, this was reflected in subsequent higher bankruptcy filings.
It is thus likely that 2022/23 will continue to see rising insolvencies as more of those supporting government policies expire. Furthermore, the sharp economic downturn in early 2022, and a more muted outlook for the rest of the year and 2023, will pressure firms’ balance sheet (see Table 2). If, on the other hand, governments return to the use of administrative measures, including further support for credit insurance, that may yet further delay the deluge of insolvencies.
Table 2: Economic outlook and insolvency
Anecdotal evidence still points to the trend of insolvencies following the developments of these economic variables. For example, the first industries we see applying for bankruptcy in 2020 were retail, followed by oil, gas, food services and tourism (see Figure 1). The impact of government policies, and their subsequent withdrawals, is borne out by the bankruptcy trends (see Figure 2), which shows bankruptcy expectations for different countries in 2022 and 2023. Generally, lower insolvencies in 2022 are expected to be followed by higher ones in 2023 upon the expiry of government interventions.
Figure 1: Bankruptcy filing by sector 2020 (figure up to 31 August 2020)
Source: GlobalData Company Filing Analytics Database
Figure 2: Insolvency growth, year-on-year % change
Source: Insolvencies increase as government support ends, Atradius Economic Research – April 2022
In summary, the respite offered by government interventions in 2020 will likely be temporary. Economic factors will once again drive firms’ performance and the probability of insolvency. For those markets that have withdrawn support earlier, the adjustment could have already happened in 2021 and early 2022. For those that have yet to wind up the support, more pain is expected in 2023. Of course, if economic growth turns out to be more robust next year than expected, the insolvency outlook will be more benign.
Implications on credit insurance
These government policies have generally been successful in terms of keeping businesses afloat and economies running. Perhaps more important, are the indirect and sometimes intangible benefits in upholding confidence and limiting contagion risks in the financial sector.
Despite this, credit insurance underwriters are rightly concerned about the bursting of the real estate bubble, disruption to the global supply chain, and rising costs of raw materials. Indeed, at the beginning of the pandemic, many industry practitioners, expected a sharp rise in the loss ratio for credit insurance, to over 200%, similar to the level observed during the 2009 Global Financial Crisis. It turns out that the loss ratio of the past two renewals is one of the lowest in our industry’s history. On average, we observed that the loss ratio of some credit insurers is as low as 20-40%. Apart from the more benign loss, the past two years also revealed:
- The importance of credit insurance to major countries as reflected in the rapid adoption of supportive policies by governments, especially through the provision of reinsurance for credit insurance.
- Credit insurers have also responded quickly and effectively, such as tightening underwriting screening, reducing exposure to affected industries, and withdrawing of unused limits.
- While the adjustments adopted thus far have helped to mitigate the risk to the credit insurance industry, they also reflect the flexibility of credit insurance and the willingness to take a more rigorous attitude towards new applications and policy renewals.
- Credit insurers also apply tighter policy terms and increase premium rates, monitoring claims and loss trends closely, even on a weekly basis.
Outlook
We have not entirely emerged from the epidemic. There are also increasingly strong headwinds, including the continuation of the war in Ukraine, rising inflation and interest rates, and a looming global recession. These developments will require us to maintain prudent underwriting, thorough understanding of the market dynamic, and the implementation of effective control and risk management measures.
Another reason to argue for caution, is that the pandemic has a long tail, at least in terms of insolvency as historically, non-performing loan (NPL) build-up takes many quarters to peak. For OECD markets, the 2009 Global Financial Crisis was 13 quarters. More broadly, a recent paper found that NPL levels keep rising for 2.4 years, on average, following the onset of a crisis.[8] This means the peak of insolvency typically lags after the crisis, and could be further delayed by government intervention. While prediction of a tsunami of insolvency has yet to materialise, underlying logic would still point to challenging times ahead.
[1] What is the economic cost of covid-19? The Economist, Jan 9, 2021.
[2] The Calm Before the Storm: Early Evidence on Business Insolvency Filings After the Onset of COVID-19, COVID-19 Notes, The WorldBank Group.
[3] The projected 40% increase is based on historical sensitivity analyses and assuming ceteris paribus. Source: “Insolvencies: We’ll be back”, 6 October 2021, Allianz Trade.
[4] See “Coronavirus – Trade Credit Insurance”, Eversheds Sutherland.
[5] See “Communication from the Commission Temporary Framework for State aid measures to support the economy in the current COVID-19 outbreak 2020/C 91 1/01”, EUROPA.
[6] The Calm Before the Storm: Early Evidence on Business Insolvency Filings After the Onset of COVID-19, COVID-19 Notes, The World Bank Group.
[7] Source: World Economic Outlook update July 2022, IMF.
[8] 64 See Anil Ari, Sophia Chen, Lev Ratnovski “The Dynamics of Non-Performing Loans During Banking Crises: A New Database”, IMF Working Paper, WP/19/272, December 2019. For the definition of banking crisis used in this paper, see Luc Laeven and Fabian Valencia “Systemic Banking Crises Revisited”, IMF Working Paper, WP/18/206, September 2018.
