Why Cross-Default Matters

We are sure most, if not all of our readers are familiar with concept of cross-default and its use in loan and bond documentation; and that you have come to accept and expect it to be “there” in any documentation governing counterparty or investment exposure.

But why does its inclusion matter? Why should an underwriter or portfolio manager care?

Paradoxically, the concept received a brief moment of fame in the “stand-off before last” over the raising of the US Federal debt ceiling, when there was legitimate concern that the US Treasury might actually default on its obligations in the sense of failing to pay interest or return principal when due. Because most people had never expected that the US might actually default, we suspect that they had probably not paid much attention to the “fine print” of a US Federal bond obligation. If they had, they would have realized (and probably been surprised) that US Federal debt obligations do not actually contain any cross-default language. This means that, had the US government actually defaulted, holders of obligations maturing far into the future would have had no ability to enforce an obligation to pay before maturity, even if they received no interest payments and the US Federal government’s “promise to pay” would have been found to be truly hollow.

Fortunately, the consequences of such an event were not tested; and the recent congressional deal appears to have deferred the problem for another day. As an aside, in the Great White North, the Federal Government was apparently able to slip a clause into an omnibus budget bill that took the right to control federal debt limits out of the hands of Parliament and into that of the Federal Cabinet. We are sure that President Obama must have sighed “If only…!”

We at Awbury have been around long enough to be able to remember the days when “AAA” corporates were a little more prevalent than they are now and when a number of the supposedly “undoubted” ones were themselves able to borrow without having to accept cross-default language. Fortunately, “undoubted” being a somewhat suspect concept and “risk free” a joke, those days are gone.

Cross-default is important, because, properly drafted, it enables a creditor to take action and have some say in the event of a default or failure to pay- subject, of course, to the constraints imposed by the governing bankruptcy regime.

However,  one should beware of Cross-Default’s bastard relative, Cross-Acceleration, which some bond salespeople, in these days of “covenant-lite” may try to argue differs little from its legitimate sibling. Not so! If those in a position to control an obligor’s destiny do not accelerate (often a banking syndicate) choose not to call a default and accelerate payment (because they are harvesting the debtor for fees and other concessions), there is little the hapless debt holder can do, becoming potentially at the mercy of those whose interests are definitely selfish and partisan.

Moral of this post: Read and understand the “fine print”, so that you can properly evaluate the risk/reward ratio.

-The Awbury Team


Zen and the Art of Insurance Underwriting

As aficionados of the classics of American literature will know, “Zen and the Art of Motorcycle Maintenance” (first published 40 years ago) has very little to do with keeping one’s Harley in good working order; and is not meant to be a treatise on Zen Buddhism either! At its core it is, in fact, an exploration of the philosophical meaning of concepts such as “Quality”.

Why is this relevant to the world of (re)insurance (beyond the prevalence of scooters and the like on Bermuda)? Because quality and philosophical consistency should underlie all that we do. Too often, companies in our industry claim to be driven by the “quality” of their underwriting and maintaining discipline in the face of softening markets and the temptation to write volume. Yet, the financial history of insurance is littered with examples of companies for which  the hope that a benign CAT season and good investment performance would bail them out of poor underwriting decisions and irrational pricing proved as illusory  as a Chimaera.

And what happens then? Assuming that management has not managed to weaken the company’s capital and franchise to such an extent that it has to go into run-off, or is the subject of regulatory action, they parade before the market and the press; express contrition; claim that they are reformed; promise to do better… and start the cycle all over again, because problems of agency act as enablers of self-interest!

It is, therefore, somewhat comforting to see that many of our peers do seem to be aware that, while 2013 may have been an unusually satisfying underwriting year, there are threats, some of which may be existential, looming; and that they should not and cannot be complacent or believe that somehow they will always be “better” or “smarter”. While the proverbial rising tide may have lifted those boats that were not already holed below the waterline, quality will out. In the face of the wave of capital flooding the market, a still uncertain economic climate, and increased regulatory burdens, the true underwriter (who does not follow fad or fashion) will maintain his or her Zen-like composure and discipline, so as to be prepared for the next “big one”, which will inevitably come.

-The Awbury Team


Regulatory Equivalence: The Lurking Risk

Managing all the issues and risks that an insurance or reinsurance company faces is no simple matter, as we at Awbury are well aware, in spite of the climatic compensations of beautiful Bermuda!

As readers will know, in many ways and in spite of supposed comity and common purpose, the world is in reality dominated by two Leviathan-like regulatory “empires” – the United States and the European Union, in which the complex, federal American approach to regulation confronts the countervailing complexity, and economic and cultural weight of the EU, as represented by the leading organs of the EU- The Council, The Commission and the Parliament. The result is often more pain, wasted effort and cost for those regulated entities which have businesses which operate across both of the “empires”.

For insurers, the elephant in the room is Solvency II and the potential impact of its concept of “regulatory equivalence” on those entities that will be subject to it (i.e., insurers with subsidiaries or branches within one or more of the 28 EU member states), but which are owned or controlled by an entity that is domiciled outside the EU, such as the US or Bermuda.

So, what exactly is “regulatory equivalence”? In broad terms, it means the recognition by one regulatory regime (e.g., that which will comprise Solvency II) that the approach and standards applied by another regulatory regime (e.g., the NAIC) are sufficiently “equivalent” for the first regulatory regime to accept that the second regime meets the standards of the first

A set of six principles are outlined (by the European coordinating body, EIOPA, which succeeded CEIOPS), for the underlying the regulatory review process that need to be met in order for a jurisdiction to be considered equivalent. They are:

  1. powers and  responsibilities  of  the   supervisory authority;
  2. authorization requirements to undertake (re)insurance business;
  3. system of governance and its regulatory oversight;
  4. business change assessment;
  5. solvency assessment; and
  6. supervisory cooperation, exchange of information, and professional secrecy.

Regulatory equivalence matters, because it affects how those institutions which are subject to its risks (e.g., US-domiciled insurers with EU-based operations, or vice versa) have to manage and report a whole range of their operations, particularly capital, collateral requirements and risk management. Not benefitting from regulatory equivalence potentially significantly increases complexity and cost. Of course, this complexity is still compounded by the continuing uncertainty over exactly when and in what form Solvency II will actually be implemented!

While Bermuda (in the form of the BMA) has already wisely sought interim recognition for the “equivalency” of its own insurance regulatory regime via EIOPA and been granted provisional recognition, the US, in the guise of the NAIC, has not yet been granted such status; and there is considerable uncertainty as to when, how and if this will be achieved- all of which leaves Boards and senior management with a continuing headache over how to deal with the situation.

At Awbury, we aim to monitor and keep on top of all key regulatory developments, as they are important to us, not only because of our own status as a Bermuda-domiciled insurer, but also so that we may assist our diverse client base in structuring and managing their risks.

-The Awbury Team