Political risk insurance (PRI) as a form of security for aircraft financiers is no longer the new, exciting product it was ten years ago. The form of cover, although less popular today, is far from moribund; many brokers at Lloyd's of London, whose underwriters are its exclusive providers, stress that they now offer a much improved version of the cover's 1980s forerunner.
Jeremy Leggett of LPH Pitman, a leading political risk insurance broker which owes much of its growth to the development of PRI, argues that this form of cover has become a settled product in the aviation finance community. While there are relatively few case histories of actual aircraft claims under PRI, the examples which have arisen have not only alerted the aviation community to a few spectacular problems, but have also thrown up a range of other questions and issues.
What are the risks which PRI sets out to insure against? In terms of securing an asset, the chief imperatives of lenders and lessors can be reduced essentially to the need to be able to repossess equipment after a default, and then the need to realise its value. In lesser-developed countries or politically sensitive nations, these requirements have to be met without political intervention by the host country. PRI exists to cover lenders and lessors against such intervention (see box for detailed definitions).
Possibly the principal benefit of PRI relates to country risk. In the financial environment of the late 1980s, with increased write-offs against third-world debt, many financiers began to find it more difficult to support the demand for leased aircraft in these countries. Tim Gwinnell, head of aviation at United Bank of Kuwait in London, stresses that PRI not only makes the bank feel more comfortable with developing country risk, but it also helps to satisfy the regulatory authorities. He explains that the Bank of England, for example, applies a 'matrix' of economic and political tests to give certain nations a credit risk weighting. Banks are then obliged to make automatic provisions against loans to some states.
This obligation would destroy the economics of many aircraft transactions, but PRI satisfies the bank regulator that loans to lesser-developed countries do not constitute country risk. As an example Gwinnell cites the Seychelles, whose national carrier is of strategic importance to the island. This operator could be considered an acceptable credit risk since a default would amount to political and economic suicide as the loss of aircraft would be devastating to the island's tourist industry. Despite this, the Bank of England categorises the island in its matrix but, as Gwinnell explains, PRI removes this problem. Banks outside the UK face similar regulations, although often not as strict.
Leggett extends this logic by pointing to the modern fleet operated by Ethiopian Airlines. He argues that only PRI allows the airline to have such a fleet; without PRI, country risk considerations would have precluded lenders and lessors from financing its equipment at economically justifiable rates. Brokers and financiers now recognise that PRI can be an invaluable tool to enable lending to lesser-developed countries.
This premise that the cover would provide comfort to lenders and regulators was behind its popularity in the 1980s. However, as there were no claims at that time, the real effective level of protection provided by PRI in the event of an actual default remained untested, and some issues could not be clarified. These issues can be boiled down to the following:
Proving a claim
One of the more contentious issues is how to prove the validity of a claim. A PRI policy is designed to protect against political risks arising from the actions of the host government, but what if political interference is the result of actions by other countries, such as those which imposed sanctions against former Yugoslavia in 1991? Two examples illustrate the issue.
Chemical Bank had financed two B737-300s for the Yugoslavian airline JAT in the early 1980s. The bank was uncomfortable with political risk exposure in former Yugoslavia, so as a condition of its funding, Chemical required Boeing to take the repossession risk. The manufacturer, in turn, subcontracted this risk to Lloyd's underwriters. However, Chemical then sold its aircraft portfolio to GECC, including the Boeing guarantee.
In 1991 the imposition of UN sanctions after the start of hostilities in Yugoslavia strangled JAT's operations and precluded it from making any debt payments, leading it into default. GECC then claimed on its 'political' guarantee from Boeing. When the manufacturer was unable to recover the assets it turned to its insurers, who settled the PRI claim and took over title to the equipment. This episode appears to show that it is possible to make a claim without insurance against a specific event.
However, a Crédit Lyonnais-led syndicate had a different experience. The syndicate had financed a B727-200 for the Belgrade-based charter carrier Aviogenex. Crédit du Nord, the largest participant in the syndicate, subscribed to PRI in the belief that it would cover itself against a whole range of political risks.
When Aviogenex suffered a similar fate to JAT, the insured bank began the process of lodging a claim. However, in this case the claim failed, and initially few observers could understand why the two parties were being treated differently.
At LPH Pitman, David Porter stresses that the imposition of UN sanctions were not in themselves the real reason for the claim's failure; rather, it was that the insured bank in the syndicate was unable to prove that the aircraft could not be repossessed. He argues that in court a judge would want to be satisfied that the intention of the banks was to repossess the equipment and that sufficient action had been taken to demonstrate this. Porter believes that the underwriters would have paid the claim if this had been proved. The problem in providing proof leads on to the second major issue.
Declaration of default
To make a PRI claim, the insured party must first declare an event of default and then try to repossess the equipment. Bertrand D'Yvoire of Consultair, consultant to Crédit du Nord, explains: 'The bank controlled 40 per cent of the syndicate, which did not give it the required majority to declare a default without the support of another syndicate member. Thus it was unable to begin the process of recovering the asset, so no claim could be made.'
Viewed in isolation, this reasoning gives the impression that the rest of the syndicate did not wish to recover the asset. However, the other banks reasoned that a Serbian court would be unlikely to permit repossession and, even if it did, the sale proceeds could not be repatriated. This position was strengthened by the UN sanctions committee, which advised that any attempt to release Aviogenex from any obligations would probably be interpreted as a violation of sanctions! The result was that the majority of the syndicate concluded that maintaining reasonable relations with the carrier would be a better way to ensure some level of recovery after sanctions were lifted.
The lesson learned from the Aviogenex case is that a participant in a syndicate is not necessarily insured against political risk if that individual does not also control the majority of the group. PRI brokers point out that this situation is extremely unusual, because such policies are usually subscribed to by syndicates on behalf of all members.
Judicial delay
A more recent case highlights a third issue. Does legal delay by the host country constitute the basis for a PRI claim? The US leasing company PLM has B737-200 aircraft on lease to the Indian carrier East West, which has defaulted on a number of lease payments. The Indian courts have so far been unwilling to grant the lessor a repossession order, partly because each time the case goes to court a payment is made.
Colin Thaine, partner at London solicitors Wilde Sapte, says that legal risk is not the same as political risk, but changes in the law or changes in the way the law is applied are political risk. Porter emphasises that a local legal opinion, which should have been sought before drawing up the contract, is an essential ingredient in subscribing to PRI and should be able to determine the level and type of risk. Porter adds that it is now possible to insure against judicial delay, but if a lessor has a clear legal opinion, which covers the time involved in going to court, there should rarely be any need to cover such a risk.
Restrictive timing
Another difficulty is that financiers are still concerned by the length of available coverage. Thaine explains in his report 'Political Risk: A Necessary Cover?' that, ideally, a PRI policy would match the term of lease or loan arrangements. In the case of a finance lease this could be for up to 15 years. Generally, the London market has not written policies for longer than three years, so there is an obvious gap.
Barry Moss, director at brokers HSBC Gibbs, says that underwriting capacity shortages in the early 1990s exacerbated the problem and for a time it was only possible to source underwriting capacity for one year. The situation has improved significantly; policies to match five-year operating leases now exist, and underwriting capacity is available for seven years.
Non-renewal clauses
Finally, the problem which has affected more policy subscribers than any other is what happens if a PRI policy cannot be renewed during the lease or loan term. Thaine suggests that 'the financier could exercise an early termination right for non-renewal, so enabling it to call for a return of the aircraft, and then, if an airline or host country were to contest its return and perceivably trigger an action of confiscation, the financier could still lodge a claim with the insurer before the policy expired.'
As with the length of cover question, this issue arose due to an underwriting capacity shortage. Moss says that those underwriters who were willing to renew cover argued that if the remaining underwriters did not renew, then the lessee could be in technical default, leading to a claim on the existing insurers. To avoid this eventuality, a non-renewal exclusion clause was added to the insurance contract. Financiers were then left with no lever to ensure that PRI would be renewed for longer than the standard three-year period.
Moss says that this reduction in the scope of cover is now being addressed. Underwriters are accepting that this clause can be removed. This increases the comfort for financiers, because were the contract not to be renewed the underwriters could be faced with a claim. But Porter counters that the problem has been more a question of pricing than of the ability to renew, with much higher premiums for cover without a non-renewal clause. LPH Pitman has always provided non-renewal protection where required by a lease agreement, says Porter.
Financiers are no longer questioning the value of PRI as far as credit enhancement and regulatory issues are concerned. Some bankers point out that when funds belonging to depositors or other institutions are lent to countries with underdeveloped legal and political systems, lenders are bound to a duty of maximum prudence, particularly after all the recent lesser-developed country debt problems. Against this background, many financiers concede that several transactions could never have proceeded without PRI.
Nevertheless, some real concerns still exist for PRI subscribers. According to brokers, many of these are either already solved or are close to resolution. The non-renewal issue faced by some brokers falls into this category. Progress has also been made with regard to the length of available cover, and it is also possible to insure against judicial delay.
Yet, proving the validity of a claim in a situation such as UN-imposed global sanctions - which nobody had previously anticipated - can remain awkward. The rare incidence of a subscription to PRI by only part of a lending syndicate still requires a clarification. Alternatively it should be made clear that a group of financiers should only subscribe if there is agreement among the majority.
Despite this progress, financiers' concerns over the effectiveness of PRI in recent years, due to some of these issues, has affected the popularity of the product. But reduced demand for PRI at the moment is more likely to be explained by the general reduction in finance leases available to carriers outside the top credits, and by the increase in export credit-backed financing.
It is reasonable to assume that when - or if - the use of finance leases to lesser-developed countries recovers, PRI will have an important role to play in that development, particularly if financiers can be convinced that the remaining difficulties have been resolved. If they can, political risk insurance could even become a catalyst for more aircraft finance activity in these regions.
In cross border aircraft finance to lesser developed countries, political risk insurance (also known as repossession or deprivation insurance) allows an aircraft lessor or lender to insure the value of its asset against certain political failings by the government of the lessee or the borrower.
Obvious political failings or 'political risks' are events such as confiscation, nationalisation or requisition of the equipment by the government of the country in which the aircraft is registered or operated. However, many other risks also exist which could obstruct, prevent or delay either the repossession, the sale of the aircraft or the normal servicing of the airline's debt. In this context, one or several of the following alarming events that are covered by PRI could happen, including:
* Inability physically to repossess the aircraft (For example, the operator may deny that the lessor has any right to repossess and this position may be supported by the local courts);
* Inability to de-register the aircraft;
* Refusal to allow the proceeds earned under a mortgage or lease to be released in a freely convertible currency;
* Inability to or delay in obtaining an export licence from local customs authorities;
* The withholding of technical records or the delivery of incomplete records due to government intervention.
It is worth noting that none of the above are covered in the normal hull war risks policy, which every operator is obliged to maintain. Consequently, many lenders and lessors need such a policy for their benefit and under their control to insure against such eventualities.
Source: Airline Business
