ECONOMYNEXT – Sri Lanka’s Construction Guarantee Fund (CGF) has faced pressure on income and claims as the government cut spending, Fitch Ratings which maintained the agency’s ‘BB(lka)’ IFS rating said.
The firm is on rating watch negative.
“The government’s weakened fiscal position has resulted in a reduction of new construction contracts, suspension of existing projects and delays in payments to contractors,:” Fitch said.
“This has affected CGF through a decline in premium income and a higher risk of claims by employers.
“CGF’s premium income plunged by 63% in 2022 to LKR107 million from a year earlier due to a reduction in guarantee volume. However, its expenses, which are predominantly fixed, rose by 14% amid rising inflation.”
CGF’s capital was adequate Fitch said, though it had fallen.
“Fitch regards the trust’s risk appetite as high given its role in offering guarantees to riskier, especially small-and-medium scale, contractors that are registered under the National Registration Scheme developed by the Construction Industry Development Authority, without requiring collateral,” the agency said.
“CGF attempts to mitigate these risks by conducting comprehensive screening of the contractors’ technical and financial capabilities.”
The full statement is reproduced below:
Fitch Maintains Construction Guarantee Fund’s ‘BB(lka)’ National IFS on Rating Watch Negative
Fitch Ratings has maintained Sri Lankabased Construction Guarantee Fund’s (CGF) National Insurer Financial Strength (IFS) Rating of ‘BB(lka)’ on Rating Watch Negative (RWN).
KEY RATING DRIVERS
Elevated Risks for Credit Profile: The RWN reflects heightened near-term downside
risks to the fund’s credit profile as a result of the ongoing economic crisis in Sri Lanka
(Long-Term Foreign-Currency Issuer Default Rating (IDR): Restricted Default). This
includes a weakened operating environment, elevated investment and liquidity risks and a
weaker financial performance outlook.
Weakened Operating Environment: CGF’s performance exhibits a strong correlation
with government construction activity, as the company offers guarantees and related
services to small-and-medium contractors involved in government construction projects.
The government’s weakened fiscal position has resulted in a reduction of new
construction contracts, suspension of existing projects and delays in payments to
contractors. This has affected CGF through a decline in premium income and a higher risk
of claims by employers.
Conservative Investment Mix: We believe the sovereign’s weak credit profile and the
continuous stress in the domestic banking system increase CGF’s investment risks.
Around 78% of its invested assets were in cash and term deposits placed with state-owned
Bank of Ceylon (Long-Term Foreign-Currency IDR: CC, National Long-Term Rating:
A(lka)/RWN) at end-2022, while treasury bills accounted for the remainder.
Pressure on Earnings: CGF’s premium income plunged by 63% in 2022 to LKR107
million from a year earlier due to a reduction in guarantee volume. However, its expenses,
which are predominantly fixed, rose by 14% amid rising inflation. We expect a continued
decrease in premium income as guarantee volumes will decline until there is a revival in
the local construction sector. Hence, investment income will be the primary source of
income in negating the earnings pressure from the topline fall and meeting CGF’s
recurrent expenditure.
Increased Claims in 2022: CGF’s combined ratio (after factoring in claim expenses)
deteriorated to around 98% in 2022 from 28% in 2021 due to claims of LKR14 million
compared with none in 2021 and the drop in premium income. Total claim initiations
since inception were low at LKR112 million by end-2022 (6.4% of equity). CGF said a
further rise in claims for 2023 will be minimal as the majority of the existing guarantee
liabilities will expire by August 2023.
Moderate Company Profile: We rank CGF’s company profile as ‘Moderate’ compared
with that of other insurers in Sri Lanka, reflecting its ‘Moderate’ business profile and
‘Moderate/Favourable’ corporate governance. CGF is fully owned by the state, with thesecretary to the Treasury functioning as the trust’s settlor. Its competitive position is
strengthened by the expertise of its trustees, which comprise both public- and privatesector institutions. It has a small operating scale with total assets and equity of LKR2.6
billion and LKR1.7 billion, respectively, at end-2022.
High Risk Appetite: Fitch regards the trust’s risk appetite as high given its role in
offering guarantees to riskier, especially small-and-medium scale, contractors that are
registered under the National Registration Scheme developed by the Construction
Industry Development Authority, without requiring collateral. CGF attempts to mitigate
these risks by conducting comprehensive screening of the contractors’ technical and
financial capabilities.
Adequate Capital: Its net guarantee risk exposure to total capital decreased to 0.4x by
end-2022, from 3.1x at end-2021. This was from net guarantees falling to LKR772 million (2021: LKR4.4 billion) on the lower volume of new guarantees and discontinuation of some projects. CGF’s capital is supported entirely by an internally generated net surplus.
RATING SENSITIVITIES
We expect to resolve the RWN once the impact of Sri Lanka’s economic crisis on CGF’s
credit profile becomes more apparent. This may take longer than six months.
Factors that Could, Individually or Collectively, Lead to Negative Rating
Action/Downgrade:
– Rising investment and asset risks, including a downgrade of the ratings of financial
institutions or the sovereign
– Significant liquidity constraints that impede CGF’s ability to service its guarantee
obligations
– Sustained weakness in financial performance or weaker risk management practices
– A deterioration in CGF’s company profile – for instance, due to significant weakening in
its association with the government – or a deterioration in its business risk profile due to a
decline in the country’s economic conditions that affects the domestic construction sector
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:
– There is limited scope for upward rating action given the RWN.