Beats | May 28, 2020

Impact insurance: Synthetic securitization to backstop small and medium-sized enterprises

Thomas Venon
Guest Author

Thomas Venon

Few are those that would under normal circumstances underwrite insurance policies against an event they deem to be highly probable. 

But these are extraordinary times, and impact investors are no ordinary investors.

Providing debt-relief to small and medium-enterprises, or SMEs, facing the economic fallout of the COVID-19 is at the forefront of many impact investors’ concerns. SMEs are being hit hard by the economic fallout from societies’ response to the pandemic, and this will most likely result in a wave of defaults and bankruptcies, the effects of which will inevitably be felt most acutely by the vulnerable.

This has in turn prompted an equally observable drive to provide relief to the stricken entrepreneurs, a laudable response, the magnitude of which can be measured in hours of video conference calls (no trademark), dollars set aside, initiatives, coalitions and, of course, fund launches.

The latter is hardly surprising. Asked what time it is, asset managers will instinctively run away and come back a few moments later with a pitch deck explaining why it is necessary to launch as large a new fund as feasible to foster the production of clocks, watches and sundials. 

In the interest of providing frontline lenders with the most efficient and timely assistance possible, the industry would do well to resist relying only on new fund launches and look to the provision of insurance as an appropriate tool. 

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Sustainable development certificates

There exist tried and tested methods to provide credit insurance on existing portfolios of loans. These contract-based solutions can in fact be nimbler and more economical than fund structures. Guarantees are more often linked to the issuance of new loans, but can be applied to existing portfolios. 

The SDC Framework, published in March by Eighteen East Capital with support from the Rockefeller Foundation, provides a number of examples of the application of ‘synthetic securitization’ to the impact space.

The paper argues that the transfer of risk through the issuance of securities (‘securitization’) would allow sustainable development stakeholders to harness the power of the global financial institutions and distribution channels. The paper identified a synthetic securitization approach centered on a Risk Participation Agreement as the most appropriate. The resulting exposure can then be transferred to investors through the issuance of structured notes, or Sustainable Development Certificates. But the specific features are less relevant than the opportunity to create a scalable market for sustainable development securitization instruments.

Efficiently offering credit insurance directly to individual SMEs is beyond the reach of most impact investing institutions. 

The scale and the complexities of the COVID crisis mean that intermediaries must be entrusted to pass the benefits of credit insurance on to those in need. Accordingly, fund managers, microfinance institutions (MFIs) and community development finance institutions (CDFIs) can play a crucial role in acting as the conduit for such coverage.

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Relatively simple synthetic securitization techniques can be used to protect the loan books of fund managers, MFIs or CDFIs against impending losses. Synthetic securitization can be defined, as per the European Parliament’s Research Service, as:

A transaction involving no transfer of legal title, but only the sale of the credit risk associated with the assets through the use of credit derivatives such as credit default swaps. The underlying assets remain on the balance sheet of the originator

As described in the paper, there are precedents for the use of synthetic securitization to create headroom with a development lens. The European Investment Fund in 2015 implemented two synthetic transactions intended to achieve capital relief for SME lending assets, with proceeds to support new origination. 

In late 2018, the African Development Bank completed Room2Run, a synthetic securitization whereby it bought credit protection on a $1 billion renewable energy loans from a U.S. credit fund. The mechanism reduces AfDB’s credit risk, lowering its risk weighting and enabling the bank to free up over $600 million to support new lending.

The SDC Framework was designed to allow development finance institutions and multilateral development banks to optimize their balance sheets through private capital mobilization. But its core engine can be readily adapted to provide last minute insurance to frontline lenders. 

As highlighted during ImpactAlpha’s recent Agents of Impact Call, ‘10x Community Capital,’ the survival of some of the more exposed CDFIs is at stake. This approach can be used to free up their balance sheet and protect their limited equity against portfolio losses.  

In the knowledge that they are insured against a specific quantum of the losses threatening their existing books, intermediaries would in turn be in a position to offer generous restructuring terms to their clients as well as increasing existing credit facilities.

Right tool for the job

The COVID driven economic crisis is an accident that we know is going to happen. The tricky part is that we do not know who it will happen to, when it will happen, nor do we know what the extent of the damage will be. 

Debt trap. The preferred route to backstop SMEs seems to be the provision of additional but concessionary debt, to allow them to weather the storm and address their immediate cash needs. This will, however, leave those businesses that survive the crisis with a considerably more stressed balance sheet. 

For many such businesses across the developing world,  equity had to date been the only suitable source of capital. If debt was not appropriate before the crisis, it is doubtful it is now that circumstances have taken a turn for the much worse. At the very least, we should favor flexible, pre-approved facilities that SMEs can elect to draw on should the need arise.

The lure of inexpensive debt, combined with deployment incentives for intermediaries presents for providers of scarce concessionary capital a serious risk of misallocation, as well as the moral hazard of delivering a more leveraged, and therefore more fragile, post-Covid world.

Grant allocations. Grant monies are obviously an extremely powerful tool in such circumstances. But when will the grant be made? In the ex-ante scenario, we are back to the difficulty linked to the uncertainty surrounding the accident’s actual occurrence and its magnitude. The risk of misallocation is here magnified by the absence of a significant financial cost for the recipients.

In the ex post facto alternative, the grant will address the exact cost derived from the accident. But such grants would run the risk of being too little too late given the sometimes justifiably lengthy grant making processes.

Insurance premiums. If ever we were able to foresee the occurrence of an accident, our natural inclination would be to subscribe to an insurance policy providing cover for the exact type of accident and up to the aggregate associated cost. Unfortunately, now that the much-increased probability of a severe accident is known to all, a request for coverage would be met by prudent insurance providers with bewilderment. 

Should SMEs however find one willing to part with said coverage for an affordable premium, this would leave them in a position to confidently take on the crisis, in the full knowledge that a pre-approved, damage-based payment would allow them to speedily get back on their feet should an accident materialize.

Whilst it is difficult to insure against loss of revenue, the financial industry has long known how to provide insurance on loans.

The provision of ‘last minute’ insurance coverage would potentially protect relief providers from the risk of misallocation, instead offering an efficient, pre-approved mechanism to make good the losses incurred by the victims. Only those suffering losses  would receive relief, in an amount equal to these losses. A modest premium would help ensure that only those reasonably certain to be at risk would subscribe, and the pre-approved nature of payouts would result in a timely intervention.

Members of the impact investing community can and should play the extraordinary role of the willing insurance provider presented with extraordinary circumstances. 

Thomas Venon is a partner at partner at Eighteen East Capital. Based in London and Cape Town, Eighteen East connects impact investing to the capital markets through financial engineering expertise.