What is non-payment insurance in the context of aircraft financing?
In simple terms, non-payment insurance is a credit risk mitigation tool. It provides lenders with an insurance policy against the risk of non-payment of principal or interest by the borrower (typically an airline). In the event of non-payment, the insured lender(s) may claim on the policy and the consortium of insurers will step in to pay the unpaid amount.
Non-payment insurance supported aircraft financings share many similarities with export credit financing.
The key difference is that, in place of a guarantee from a government export credit agency (ECA), the lender(s) instead have the benefit of a non-payment insurance policy issued by a consortium of highly-rated insurers insuring the lender(s) against the risk of non-payment of principal or interest by the borrower. The insurance policy means that the insurers bear the credit risk of the transaction. These insurance products allow available capital in the insurance market to be put to work financing the considerable and growing global demand for capital for new aircraft deliveries.
Origins and development of non-payment insurance aircraft finance products
Non-payment insurance has been used by aircraft financiers for many years privately "behind the scenes" to mitigate credit exposures to airlines and leasing companies. This note looks at aircraft financing products that incorporate non-payment insurance overtly as a key component.
AFIC programme
A consortium of global insurance companies assembled by insurance broker Marsh LLC, known as the Aircraft Finance Insurance Consortium (AFIC), was the first to market an aircraft financing product in which non-payment insurance was an overt and key structural component. The AFIC programme was originally developed in 2017 as a substitute for financing supported by the Export-Import Bank of the United States (USEXIM) at a time when USEXIM's ability to support the financing of large commercial aircraft was temporarily suspended. The similarity of AFIC's documentation with that of USEXIM supported financings was one of AFIC’s original selling points to airlines. AFIC supports the financing of Embraer and Boeing aircraft.
Balthazar programme
Insurance broker Marsh S.A.S. (France) developed a non-payment insurance supported programme, branded "Balthazar", supporting the delivery of Airbus and ATR aircraft. The Balthazar programme was created to provide an additional source of financing to support for Airbus Group aircraft purchases.
Similar products
Both AFIC and Balthazar are well-established aircraft financing products, existing alongside and complementing export credit financing. Following the successes of AFIC and Balthazar, other similar products have been launched into the market, for example, the Integrated Finance Linked Insurance (IFLI) product and Itasca Re's reinsurance offering.
Transaction structure and documentation
Finance lease structure
Non-payment insurance supported transactions typically use a finance lease structure, where the aircraft is purchased and owned by a bankruptcy-remote orphan SPV using a secured loan borrowed from the lender(s) and leased to the airline, which has the benefit of a purchase option at expiry of the term. The loan typically covers up to 85% of the aircraft's value and amortises the acquisition cost of the aircraft over a term of 10 or 12 years. For some transactions, particularly those with a US airline, a secured loan directly to the airline may be used in place of a finance lease.
Finance lease documentation
Where structured as a finance lease, the principal transaction documents will be:
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A loan agreement between the lender(s) and the SPV borrower.
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A finance lease agreement between the SPV borrower and the airline.
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In some cases, a participation agreement or all-parties agreement setting out common terms.
Security package
The lender(s) and the insurers benefit from a security package usually comprising:
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A mortgage over the financed aircraft
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Assignments of rights under the finance lease, the insurances and manufacturer warranties.
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A charge or pledge over the shares in the SPV borrower.
When is the insurer party to the principal documents?
In an AFIC financing, one of the consortium of insurers is designated as "insurer representative" and is a party to the principal loan documents entered into with the SPV borrower. This means that the AFIC insurers, via the insurer representative, effectively assume documentation risk as well as credit risk therefore the principal loan documentation is typically drafted by counsel to the AFIC insurers. For Balthazar financings, in contrast, the Balthazar insurers are not usually directly party to the borrower-facing financing documents (this is more like a traditional private "behind the scenes" credit insurance arrangement).
Key terms of a non-payment insurance policy
Insured amount
The non-payment insurance policy typically covers 100% of the insured loan so, unlike for many traditional credit insurance arrangements, there is no requirement for the lender to retain a portion of the risk. Once issued, the policy is non-cancellable.
Insurance written on several basis
The insurance is written on a several basis with each insurer responsible only for its own share of the risk.
Insurance premium
A premium is payable to the insurer for the non-payment insurance. The premium is typically payable in full on financial close for the full term of the financing and is not usually refundable in the event of voluntary early prepayment or termination of the financing. This is similar to the exposure fee payable to the relevant ECA in an export credit financing (a fee assessed on each disbursement of the loan compensating the ECA for the assessed risk associated with the transaction). The cost of the premium is borne by the SPV borrower, but is usually financed in full by (and added to the principal amount of) the insured loan, so that the cost is amortised over the term of the loan.
Cross-collateralisation requirement
Insurers usually require cross-collateralisation between all non-payment insurance supported financings for a particular airline, regardless of the identity of the lenders on the various financings (this is similar to export credit financings). The cross-collateralisation is usually effected by the SPV borrower giving a guarantee to the insurers in respect of the other financings to be cross-collateralised. The guaranteed obligations are caught by the scope of the obligations secured by the security documents and included in a pre-determined order of payments (or payments waterfall) in the participation agreement or all-parties agreement. Typically the waterfall will provide for proceeds in relation to an aircraft to be paid first towards the secured obligations in respect of that aircraft which are covered by the non-payment insurance, then to payment of any secured obligations in respect of that aircraft which are not covered by the insurance, and thereafter to the cross-collateralised obligations in relation to other aircraft.
Making a claim under the insurance policy
Following a default by the SPV borrower in payment of an instalment of principal or interest, the insured lender(s) may claim on the policy and the insurers will step in to pay the missed instalment. The insurers will continue to pay all scheduled instalments of principal and interest as they fall due until the earlier of the end of the period specified in the policy (the period varies on a case by case basis but is usually between 18 and 36 months) or the disposal of the aircraft. On disposal of the aircraft the insurers will pay the remaining outstanding principal and accrued interest to the lender(s). For some fixed rate loans, the policy may give insurers the option to continue paying scheduled principal and interest for the remainder of the term in accordance with the original amortisation schedule, meaning that no fixed rate breakage costs arise and thereby avoiding the question of whether or not such breakage costs are covered by the policy.
Insurers' rights of subrogation
The insurance policy gives the insurers a right of subrogation. Once the insurers have paid a claim in relation to an unpaid debt of the borrower, the insurers are subrogated to the lenders' rights in relation that debt. In addition, the insurance policy will typically provide that, on payment by the insurers in full of the outstanding debt, the insurers are entitled to require the lenders to assign to the insurers all of their rights against the borrower under the finance documents.
Regulatory capital position
Effect of insurance policy on lender's regulatory capital requirement
The AFIC and Balthazar insurance policies are intended to work as an unfunded credit risk mitigation technique for the purposes of determining a lender's regulatory capital requirement under the relevant prudential regulatory regime.
The effect of non-payment insurance on a lender’s regulatory capital requirement is essentially to replace the lender's exposure to the credit of the airline or leasing company (in other words the financial risk that the airline or leasing company may refuse, or be unable, to repay the loan) with exposure to the (better) credit of each of the credit insurers. Assuming the insurance policy satisfies the regulatory eligibility requirements, the higher credit rating of the insurers results in a lower risk weighting being applied to the lender’s loan to the airline or leasing company (as the lender is treated as having an exposure to the insurer rather than to the airline or leasing company). This lower risk weighted exposure results in a reduced capital requirement for the lender.
Policy features to meet eligibility requirements
The non-payment insurance policy includes certain features designed to ensure that it meets the eligibility requirements to be treated as an unfunded credit risk mitigant. These features include some or all of the following:
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The policy does not allow the insurer to unilaterally cancel or terminate the policy, change its terms, or demand additional premium.
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There are no exclusions to policy coverage that are outside the control of the insured (the lender(s)) except for fraudulent, illegal or criminal acts by the insured.
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The warranties required from the insured under the policy, if any, are very limited and there are no or very limited conditions precedent to coverage.
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The insured's duty of fair presentation under the Insurance Act 2015 is limited by the terms of the policy.
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The policy provides for payment on a short timeline after a claim has been submitted and verified in order to satisfy the eligibility requirement for payments to be made "in a timely manner".
Reasoned legal opinion requirement
In addition to meeting the eligibility requirements, the policy must be enforceable against the insurers. Therefore the lender must obtain a reasoned legal opinion on the enforceability of the policy for the purposes of Article 194 of the UK CRR, usually supported by a memorandum of advice dealing with the policy's compliance with the eligibility criteria described above.
Advantages for airlines and leasing companies
There are a number of advantages for airlines and leasing companies using non-payment insurance supported financing products, including:
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From the airline borrower's point of view, non-payment insurance supported financing products offer long-term financing at an all-in cost (in other words, the margin plus the non-payment insurance premium) that is lower than the margin that the strength of their credit would normally attract. These products appeal to the same types of borrowers that might typically use export credit financing.
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Airlines have been the main users of non-payment insurance supported financings. Mid-tier airlines particularly benefit because their own borrowing costs are materially higher than those available with non-payment insurance supported products yet their credit standing is still sufficient to meet the underwriting requirements of the insurers.
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Leasing companies also use these products, which are available to lessors on both a full recourse and limited recourse basis. They are likely to be most attractive to lessors that do not have an investment grade rating and, given the “locked-in” pricing of the product (the non-payment insurance premium is payable in advance and is not refundable in the event of early termination), are more appropriate for a lessor looking to hold the asset for the longer term than for a lessor expecting to trade it during the term of its initial lease.
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Non-payment insurance supported financings can be combined with tax-enhanced equity structures such as JOLCOs (Japanese operating leases with purchase option) and French tax leases to provide airlines with overall financing for 100% of the acquisition cost of the aircraft at attractive rates.
Advantages for lenders
From the lender's point of the view, non-payment insurance supported financing offers a means of participating in the aviation finance market with a significantly reduced credit risk exposure and consequentially an enhanced regulatory capital position. Lenders active in the market include both established aviation banks, but also institutional investors without significant pre-existing aviation expertise.
Increased flexibility compared to ECA supported financings
Non-payment insurance supported financings offer greater flexibility for airlines and leasing companies than export credit financing, for example:
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Unlike government export credit agencies, commercial insurers are not bound by the terms of the OECD Aircraft Sector Understanding, and are therefore able to offer more flexibility on terms. For example, while export credit financings usually amortise down to zero over the term of the loan, insurance-backed financings can in some cases amortise to a balloon payment at expiry, meaning the amortisation profile of the debt better matches the amortisation of the value of the underlying aircraft, reducing the repayment instalments which the airline is required to pay.
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The informal "home country rule" (an unwritten, informal understanding among the ECAs in the US, UK, France and Germany that they would not provide financing for competing aircraft that will be principally located in their own or in each other’s countries) does not apply to commercial insurers, so insurance supported financing can be made available to US, British, French or German airlines.
There is greater flexibility in the form of documentation that the parties may use.
Potential limitations
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Premium structure assumes aircraft held for longer term. The requirement that non-payment insurance premiums are paid in full in advance and are not refundable on early termination means these products are most attractive to borrowers expecting to hold the aircraft for the longer term (in the same way as for export credit financing), unless insurers are prepared to agree to partial premium refund in the event of early prepayment which is not a feature usually found in these structures.
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Insurer downgrade and insolvency risk. The products rely on the backing of commercial insurance companies rather than government export credit agencies. This means the issue arises of how an insurer credit rating downgrade or insolvency should be dealt with in the transaction documents which can lead to a difficult negotiation between borrower and lender. Lenders may require a mechanism for a downgraded or insolvent insurer to be replaced. Borrowers, on the other hand, may take the view that the risk of an insurer downgrade or insolvency is one for lender(s) to take (in part, because a downgraded insurer will still continue to provide cover, unless insolvent) and having paid the premium for the insurance coverage for the full term in advance, may resist taking any risk on insurer downgrade or insolvency.
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Limits on insurer underwriting capacity and lender exposure. The growth of these products is potentially constrained by:
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limits on the underwriting capacity of the relatively limited number of insurers active in the credit insurance market holding the requisite high credit ratings; and
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the fact that many lenders will already routinely purchase non-payment insurance privately “behind the scenes” from the same insurers that participate in the AFIC and Balthazar consortiums as a means of mitigating borrower credit exposure, so will already have exposure limits to certain insurers that risk being exceeded by significant exposure to AFIC, Balthazar and similar non-payment insurance-supported structures.
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Insurance regulation. Insurance is a highly regulated area and insurance regulation has an impact on these structures. For example, a particular insurer may, as a result of its regulatory status or licences, be able to issue policies only to lenders in certain jurisdictions. These considerations will need to be taken into account when structuring a deal, for example, when choosing the particular entity within an insurance group to underwrite the policy, deciding whether a particular insurer entity should front for other insurers in the group or drafting conditions to the lenders' rights to transfer the loans. Sometimes these issues may be mitigated by setting up a "lender SPV" in a suitable jurisdiction to act as a conduit for the underlying lenders' funds and to be the insured party under the policy.
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Insurance premium tax. In certain jurisdictions and circumstances, insurance premium tax may be payable on the insurance premium. Transactions need to be carefully structured to mitigate such risks.
Reproduced from Practical Law with the permission of the publishers. For further information visit www.practicallaw.com.
Authored by Russell Green and Shalini Bhuchar.
