Of paramount importance: Financial Express: October 14, 2010

The news about Paramount Airways and Oriental Insurance Company is interesting as it opens up a debate on a larger question on credit cover in the form of credit insurance. This is even more relevant, given the backdrop of the financial crisis, which has brought credit risk to the forefront. A debate is necessary, even though there have not been many instances of such defaults leading to turmoil in the financial sector.

The case is quite straightforward. We have an airline company that took a guarantee from a set of banks against which it bought fuel from oil companies. These loans were covered by an insurance company for credit default. Now the company is unable to pay, invoking the guarantee, which means that the banks have to pay the oil company. The banks, in turn, claim the loss on the account from the insurance company. As a result, Irda has decided to do away with such credit insurance schemes until a regulatory structure is put in place. The problem is significant because the insurance company did not reinsure these loans. Reinsurance would have helped diversify the risk across more players.

Credit insurance schemes are generally used for foreign trade and not commonly used by banks to cover defaults on their books. Banks covering credit risk is not uncommon in countries like the US where insurance can be procured on loans. AIG had to pay banks when the CDOs failed, and the rest as they say, is history. Credit default swaps can also be used, wherein the third party picks up the risk in exchange for a fee—the swap spread.

In India, RBI has published guidelines for CDS for bonds to make the market more robust. However, bank loans are not covered. Thus, credit insurance does appear to be a fairly good form of financial engineering for diversifying risk and expanding business—for the borrower, lender, guarantor and cover provider. This way banks would be better able to lend or provide a guarantee when loans are on the borderline.

Irda has recently barred insurance companies from selling such policies as it felt that the market is not transparent and has little regulatory oversight. The participants from different segments covering different financial arenas has led to a regulatory overlap. The concern is that insurance companies may not be sufficiently equipped to evaluate such loans when providing a cover. The system can, therefore, be gamed by intermediaries who could get the borrower to actually pay the premium to the insurance company, embedded in the bank guarantee cost for the bank. Hence, the risk from one sector would get transferred to the insurance segment, jeopardising the balance sheets of these companies. There has been reason for separating the banking sector from the insurance sector and while this concept of credit guarantee would work well in good times, it could be destabilising in times of crisis.

From a bank’s point of view, this raises issues of the quality of credit appraisal. Banks that are insured would be tempted to be more liberal in credit appraisals, knowing that the insurance company is there to back it up. In fact, the reason for a bank's intermediation job is that it bridges the information asymmetry between savers and borrowers, and takes on risk based on its superior credit skills, earning a spread on the money. If they were to go back to the insurance company, however, then they are not efficient.

Theoretically, insurance companies should insure any product that carries risk. But, when there are efficient derivative markets that price risk well, insurance companies should not participate—they are not equipped to gauge this risk. Alternatively, insurance companies could hone their skills and have a proper line of business where credit is insured.

A solution here is to take recourse to the CDS market and allow a bank to get cover from it. This implies that RBI should open the CDS market for bank loans as well, possibly in the second stage of expansion.