Covering all bases
Insurance has never had much of a place in the P2P sector, but credit insurance promises to deliver that elusive prize: high returns without the risk. Is the P2P sector ready to upend its business model?
Insurance is the enemy of risk. It steps in when things go wrong and offers a safety net for life’s worries. But it has never really had a place in the world of peer-to-peer lending. However, this may be about to change, as a series of platforms start to consider the potential of credit insurance as a way of mitigating the risk that characterises the sector.
Despite its strong track record, P2P lending is still seen as an alternative investment. At its core, the P2P model relies on borrowers being able to pay back their loans with interest. However, as every bank and private lender in history can attest, sometimes those loans do not get repaid.
Depending on who you ask and the sort of loan that you are funding, the default rate can be anywhere between one per cent and five per cent. Most platforms get around this issue by spreading investments across a series of loans and performing rigorous credit checks on all borrowers, but the risk of default is almost impossible to avoid. Credit insurance offers a solution of sorts, by helping to minimise any losses which might cause a P2P borrower to default on their loans. However, it is not without its critics.
“There’s nothing that we’ve done in all of our research that suggests that people are looking to mitigate risk in that way,” says Bruce Davis, chief executive of Abundance.
“They would rather invest in a range of different risks and pursue diversification. I’ve never really understood the economics of the insurance offer – who is it insuring anyway? We all have an insurance policy on our savings which we pay for as the taxpayer. That’s one of the reasons why we have almost zero return on our savings.”
Not every platform agrees with Davis on this issue. In fact, some platforms have already taken steps to minimise and even eradicate risk on their investment portfolios, by making credit insurance a key part of their business model.
Every P2P lender already has some form of insurance, whether it is professional indemnity, public liability or director’s insurance. But credit insurance is different. While the platform might negotiate a favourable rate for its users, it does not buy the insurance itself, leaving its borrowers to purchase it before they can apply for a loan.
“Strictly speaking, we don’t have any insurance,” explains Angus Dent, chief executive of ArchOver. “What our clients are doing is taking out a credit insurance policy to cover the payment of their debtors. So if the loan isn’t repaid, either because they are unable to pay or because they are being unreasonable about causing ‘undue delay’, then the credit insurer will step in and pay that invoice.”
Under its “secured and insured” model, ArchOver requires all its borrowers to sign up for credit insurance via the insurer Coface, at a standard rate of 0.149 per cent of the borrowing company’s turnover. If they don’t accept the insurance cost, they can’t access “secured and insured” funding. The only exception to this is if all the borrower’s clients are government or quasi-government offices, because, as Dent says, “if the government stops paying its debts we all have bigger problems to worry about!”
According to Dent, the most common reason that companies do not repay loans is because their customers have not paid them. The addition of credit insurance provides peace of mind for both the borrower and lender alike, as it means that the loan will always be repaid one way or another.
This is an understandably attractive prospect – to be able to offer lenders P2P-style interest rates, but with a zero per cent risk of default. It is therefore no surprise to learn that more and more platforms are investigating the possibilities of becoming insured.
Lisa Humphries is a director at Credit Risk Solutions, an insurance broker which specialises in credit insurance. She says that demand from P2P lenders has been increasing in recent years, although she will not reveal which firms are in current negotiations to obtain credit cover.
“Around four or five years ago it was something that the sector looked at and decided that the cost didn’t necessarily work for them,” she says. “However, what’s changed is the cost of the credit insurance is now cheaper, and right at the outset some of the P2P lenders have had bad debt and realise that had credit insurance been in place, the bad debt wouldn’t have happened. Now a lot of them insist that the debtor balances are credit insured and it’s something that – particularly in the last two years – they’ve started to be insistent on.”
While ArchOver has been using credit insurance for years, it is still a surprisingly underused tool in the P2P sector at large. Lending Works was the first P2P platform to make insurance a key part of its business model, introducing the “Lending Works shield” in late 2014. The shield insures against borrower default risk, fraud and cybercrime, and it is funded by a combination of reserve funds and insurance policies.
And last year, Money&Co’s Nicola Horlick told Peer-to-Peer Finance News that she plans to launch an insurance product that investors can buy alongside the Innovative Finance ISA (IFISA). The still-to-be-launched product would most likely be done through an investment-linked life policy, and would cover investors against a loss of up to 25 per cent on their portfolio.
“We’d rather do that than have an insurance-type fund like Zopa,” she said at the time. “I have issues with that, as if you take two per cent of the return and stick it into a pool and the losses are actually less than two per cent, over time a large amount of money is left sitting in that pool.
“The question is who owns that reserve? It’s a bit like an orphaned asset.”
ArchOver’s Dent adds that “a provision fund is almost like credit insurance that you are administering yourself,” and this sentiment is echoed by Davis, who accuses them of “diluting returns”.
“Provision funds are a form of mitigating risk and diluting returns,” he says. “As long as people understand that they are diluting their returns then that’s fine. But people should not expect that a provision fund has no effect on their return.”
The issue of cost value is at the heart of the insurance debate. Cheerleaders such as Dent argue that the small initial cost of the credit insurance brings the overall cost of borrowing down and protects against big losses. But Davis believes that by over-insuring P2P investments, lenders are eroding away their returns in the face of a relatively small risk.
“The future of the market is that we are offering a real investment to people,” says Davis. “This seems contrary to the policy of insurance as it falls into the trap that banks are in, where they have been regulated to the point where they can barely invest their own money in anything useful.
“Arguably we began because the banks were becoming these insured entities. We don’t want the P2P market to become like the banks.”
Credit insurance is not necessarily suitable for all P2P lenders and it may not be cost effective when it comes to smaller loans, as the success of the product relies on the platform’s ability to keep costs as low as possible. This means that for platforms dealing predominantly with consumer loans, a self-administered reserve fund or provision fund may make more sense. However, Humphries argues that formal insurance is an inevitability, at least when it comes to small business lending.
“P2P lenders are in competition with all the banks and finance houses and however you dress it up they all have some form of credit insurance or bad debt protection that they charge for,” says Humphries.
The credit insurance market is huge and well established, but that does not mean that it is a catch-all solution for the P2P sector.
Used correctly, and priced competitively, it could help to attract more cautious investors and more robust borrowers, bringing P2P lending closer towards the mainstream. Only time will tell whether insurance will be the making of, or the weakening of, the P2P brand.