The Basics of a Risk Participation Agreement
A risk participation agreement is a legal instrument that defines the relationship between a primary lender or party to a financial transaction, often a bank, and one or more participants who share some economic interest in the transaction. The participants enter into the risk participation agreement so that they can better share in the benefits, as well as the responsibilities, of an extension of credit made by the sponsor to the ultimate borrower.
The risk participation agreement specifies the rights and obligations of the sponsor and the participants in the underlying credit transaction. Therefore, the risk participation agreement will include references to the final loan documents (i.e. loan agreements , notes, guarantees, mortgages, security agreements, etc.) of the underlying credit transaction. Among the primary purposes of a risk participation agreement is for the participants to take advantage of the stronger balance sheets or more desirable credit ratings of the sponsor, and by doing so, the participants sometimes pay the sponsor a fee. The deposit of the participation fee by the participants typically results in a partial interest in the underlying credit transaction being transferred from the sponsor to the participant(s). Such transactions may be structured as modified swaps to take advantage of interest rate or other swap benefits.
Who are the Main Parties in a Risk Participation Agreement?
A risk participation agreement involves three primary parties: the lender, the participant, and the borrower. The lender is the bank or financial institution that extends credit to the borrower. It receives the loan proceeds from the participant upon signing the risk participation agreement. The borrower is the organization that obtains the credit from the lender. They must provide financial information to both the lender and the participant to ensure proper assessments are made. The risk participant is the group of investors or partners interested in sharing the legal risks of the loan. They assume a portion of the legal risks in exchange for a portion of the fees paid by the borrower. They may require a fee in return for their participation in the loan agreement, but they will not need to perform due diligence on the borrower. Not all lenders will be glad to enter into risk participation agreements with a participant. Some lenders will grant only to experienced participants or those who have first had a successful transaction with them. Experienced participants should have no problem securing an agreement. Those without experience should work with a legal counselor with experience in risk participation agreements.
Advantages of Risk Participation Agreements
The primary benefits of risk participation agreements are that they reduce the risk to the lenders as well as the participants. Depending on the number of participants, the risk may be divided into very small portions that are manageable for each of the participants. In the event of a default, the risk is spread over many different loans or borrowers and creates much less of a problem for the participants. A second benefit of using risk sharing agreements is that they create the ability for the lender to make much larger loans. The lender can effectively share a loan with other lenders and thereby have the ability to lend more money than it could independently. This allows lenders to work together cooperatively to create larger loans to meet the needs of their borrowers.
How Does a Risk Participation Agreement Function?
Risk participation agreements are typically entered into by an insured and two or more insurers – usually one primary insurer and one or more excess insurers. The first step involves a verbal agreement reached between the insurers – the primary and the excess insurer(s). In other words, the insurer accepting the risk or the primary insurer (its "Participant") agrees to accept a percentage of the risk of loss and to participate in a loss sharing structure jointly with the excess insurer(s) who will provide reinsurance to the primary insurer with respect to that particular risk. This is usually done via email or other written communication. Thereafter, an agreement (the Agreement) is entered into and signed by all parties.
A typical Agreement will contain the following information:
a. the date of the Agreement;
b. the scope of the Agreement can be identified through the inclusion of a specific agreement in a specific amount for a specific time period with a specific risk or risks, or a general section referring to a class of risks, a geographical area where these risks are located and a time period;
c. the risk participation percentage (i.e. share of the risk);
d. specifics regarding the certificates of deposits issued in lieu of premiums down to a specified level of risk;
e. specifics regarding flow down provisions and underwriting criteria; and
f. specifics regarding how the initial premium is calculated.
Based upon the Agreement and its governing terms and conditions, the primary insurer (its "Participant") will then transfer specified risks to the excess participant. The transmittal of the risk or risks is usually completed through the use of certificates of insurance (Certificates). Certificates are typically prepared by either the primary insurer or the excess insurer or broker and analysis is performed by the excess insurer to determine if the risk is acceptable for participation.
A Certificate is normally prepared and sent from the primary insurer to the excess insurer whenever a policy or policies subject to the Agreement are written or renewed that contain a risk within the scope of the Agreement. Although most excess participants prefer to have a Certificate issued each time a policy is written or renewed, depending upon the terms of the Agreement, it is not always necessary for a Certificate to be issued after a policy is written or renewed. Instead, the primary insurer may be permitted to issue Certificates for a single risk or a series of risks to be included in a policy.
Once received, a Certificate is reviewed by the excess insurer to determine whether the policy in question is permissible under the terms of the Agreement. If so, the excess insurer will sign the Certificate and return one or two copies to the primary insurer. The primary insurer holds these copies of the signed Certificate and provides copies of the signed Certificate to others, including the insured and insurance brokers. Although Certificates of insurance are negotiated between and among the parties, they usually are provided by the excess insurer to the insured, upon request.
Typical Provisions of a Risk Participation Agreement
Like any other contract, a risk participation agreement will contain clauses that are fairly standard, although each agreement may include additional provisions that are not universally contained in such agreements. On the whole, there are certain clauses that you can expect to see in most risk participation agreements, which may be grouped into several categories.
Termination provisions
Termination provisions typically include terms for automatic termination and for right to termination. Automatic termination occurs upon such events as dissolution of one of the parties or bankruptcy of one of the parties. The right to terminate generally involves a notice threshold. The notice period may be as short as 15, 30 or 60 days or as long as 90 days. The second type of termination may involve a specified number of years or expiration of a specified policy term. Regardless of the base period, there is a risk that an anticipated renewal could fall through , thereby raising the spectre of a gap or termination and creating a need for additional arrangements.
Indemnity provisions
Indemnity clauses in PTA’s address issues of liability and loss. Indemnity provisions require one party to protect and indemnify the other and to keep the other party whole from a third party claim for liability or loss. Indemnity provisions and the additional availability of insurance for such liability claims by the indemnifying party or participant (in effect the reinsurer) serve to eliminate or minimize this risk. Such clauses also define the scope of indemnity and the extent of such indemnity.
Confidentiality provisions
Confidentiality provisions are very important to the integrity of the agreement. Much of the information exchanged between the parties when negotiating the agreement, and the terms of the agreement itself, are sensitive. The parties will want to make sure that this information stays private and confidential and is not available or visible to the competitive field.
Laws and Regulations Applicable to Risk Participation Agreements
The legal and regulatory framework that underpins risk participation agreements can be quite complex, given the international scope of specialty lines of insurance, and the requirement for compliance with the laws of multiple jurisdictions. The supervisory authorities in many jurisdictions actively monitor the use of risk participation agreements, with specific regard to the extent to which such agreements may be used to circumvent minimum capital gain requirements or unilateral state-mandated requirements. States, such as California and New York, and foreign countries, such as the United Kingdom, have adopted particular approaches to the regulation of risk participation agreements.
For instance, it is widely known that California requires that reinsurance accepted from any unauthorized insurer must be authorized for admission by the Commissioner of Insurance. The Office of the Insurance Commissioner has become increasingly vigilant regarding risk participation agreements with respect to the ceding rules, including the extent of risk ceded to risk sharing pools. The OIC has become especially vigilant in its review of RPA’s where the share of the risk ceded by the ceding insurer is less than the net retention limit of the pool and the aggregate amount ceded by the ceding carrier. The California Department of Insurance Bulletin dated October 14, 1998 discussed the various situations where reinsurance must be authorized for admission or obtain approval.
On September 23, 2011, the California Department of Insurance issued an opinion pertaining to surplus lines risk sharing pools, in which expressed concerns about the violation of the "unilateral state requirements" doctrine. Surplus lines risk participation pools should explicitly provide that the pool shall be subject to the laws of the jurisdiction where the master policy of the pool is issued. The pool’s insurance regulators should review the individual members of the pool on a regular basis to determine whether there are any compliance issues with the underlying member companies. Moreover, insurers who participate in surplus lines pools should obtain approval from their domiciliary state regulatory authority prior to participating in a RPA to ensure compliance with unilateral state provisions and other possible adverse regulatory consequences.
In addition, in the 2012 "Risk Sharing Pools as Captives: The Devil you know versus The Devil you don’t" White Paper on various captive insurance strategies, the National Association of Insurance Commissioners has flagged concerns when captives and risk sharing pools are formed for the purpose of avoiding the "usual and customary requirements" imposed on the group members by their domiciliary state insurance regulators. Due to multiple variables in writing coverage and the unique difference of captive insurance strategies, NAIC expressed a need for State Uniformity with regard to Risk Sharing Pools and Captives and adopted Group Solvency issues.
Potential Risks and Challenges in a Risk Participation Agreement
Recognizing the importance of risk participation agreements, it is equally essential to understand the risks and challenges associated with them. Counterparty risk is one of the first concerns. If a risk participating bank defaults on its obligations, the institution left holding the credit risk may be left to deal with the situation on its own. In that case, the easier it is to offload the exposure, the better. Very few institutions choose to bear more credit risk than they need to.
Another concern lies in how to obtain a satisfactory credit agreement that will meet general expectations. Counterparty approvals can be a time-consuming process as well as require heavy vetting, a process that may vary wildly among institutions. Deep legal, operational and other resources may be called upon to complete the transaction satisfactorily .
A risk participation agreement in which the "lead" bank pays or receives the loan interest and principal and then divides the participation fee and share of the premium on the loan among the risk participants may prove to be the least risky way to go. A risk-sharing loan can be more costly, and not all banks will participate in this way. This type of arrangement can be even more difficult to accept by some banks, so the cost of use and the acceptance criteria may be higher.
Risks also include fraud, which is a concern in these types of arrangements because institutions may be largely unaware of the creditworthiness and condition of the underlying obligation. This is especially true with credit-related participations. Fraud can result from the origination and underwriting process as well as the servicing or maintenance process. Therefore, if one party is unscrupulous or careless, the other party may be left to bear the brunt of any loss.