May 11th, 2011

Succeeding Under Solvency II, Reinsurance and Counterparty Risk: Solvency II Counterparty Default Risk Considerations

Posted at 1:00 AM ET

David Flandro, Global Head of Business Intelligence, Claude Lefebvre, Head of GC Analytics EMEA Region, Mark Shumway, Senior Vice President
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Assessing Counterparty Default Risk

Counterparty default risk is one of the core components of the Solvency Capital Requirement (SCR). This module has undergone substantial change over the several quantitative impact studies (QIS) as the supervisors attempted to find an appropriate measure of the risk. In the QIS 5 final report, EIOPA noted that this module received the most criticism for the “overly complex approach” relative to the materiality of counterparty default risk within the overall risk-based capital requirement (3). We expect to see additional changes that will simplify the calculation of risk.

For QIS 5, counterparty risk exposures were classified as one of two types: Type 1 exposures are based around risk-mitigating contracts with counterparties that are likely to have credit ratings, including reinsurers, banks, cedents and derivative and securitization counterparties; Type 2 exposures encompass all others, including intermediaries and policyholders. Type 1 exposures are assessed based on probability of default as determined by credit ratings as follows (4):

solv-ii-white-paper-3-table-1-small

solv-ii-white-paper-3-table-2-small

Formulas for loss-given-default (LGD) vary based on the type of risk mitigating contract. For reinsurance and securitizations, LGD is defined as 50 percent of the sum of the best estimate recoverables from the reinsurance contract (or special purpose vehicle (SPV) in the case of an ILS) and any other related recoverables plus the risk mitigating effect on underwriting risk of the reinsurance in consideration, less the risk-adjusted value of any collateral in relation to the reinsurance. This is shown in the formula below. Calculating the risk mitigating effect on underwriting risk for every reinsurance contract and for every reinsurer can clearly be a daunting task for any insurer. Certain Type 1 exposures in which there are over fifteen independent counterparties are also assessed at the simplified Type 2 level. Reinsurance assets will be recorded at fair value based on best estimate of recoverables.

LGDi = (50% . (Recoverablesi + RMre,i – Collaterali),)

In addition to the complexity of the calculation, the assessment of default probability remains centered on ratings, and this is not expected to change before implementation. Solvency II thus takes the basis that insurers already use to assess financial strength (ratings) and complicates the approach. Indeed, this approach further institutionalizes the reliance on fundamentally flawed indicators. A more robust, though admittedly still complex, approach would take a page from the Basel III proposals and establish liquidity requirements based on market instruments (collateralized debt securities, bonds, etc.) for reinsurers that have them (5).

Other problems with the Solvency II approach to counterparty risk identified by QIS 5 participants and other parties include difficulties in determining the risk-mitigating effects (and the counterparty risk) for reinsurance programs that include more than one counterparty; a three-month limit for past-due exposures; risk charges for cash deposited with a bank that can be higher than the charge for a bond issued by the same bank and no risk charges for investments in sovereign debt (despite the ongoing European sovereign debt crisis) (6). EIOPA and supervisors will consider a wide range of simplifications for this module to address these issues prior to implementation.

Counterparty Default Risk Management

Whatever the final method for assessing counterparty default risks under Solvency II, this is an opportune time for companies to revisit credit risk management to ensure not only compliance with regulations but also to limit this non-core risk. Insurers transact with numerous counterparties, including policyholders and agents, corporate bond issuers and asset managers, reinsurers and, of course, reinsurance intermediaries.

Counterparty default risk is a by-product of dealing with each of these groups. Inevitably, some of these counterparties will default, missing or significantly delaying payments when due. Without measures in place to protect against loss, counterparty default can subject the insurance company to potentially significant financial loss. Risk management efforts should focus on limiting the impact of losses by screening through internal guidelines, diversification (with an eye on tail dependencies) and diligent monitoring. Our recommendations in each of these areas follow.

Maintain Internal Guidelines

Strong guidelines inform analysis and allow reinsurance buyers to screen out counterparties that are most likely to present the highest levels of default risk. Guidelines should allow qualitative measures as well as quantitative benchmarks, and should include metrics on claims payment and past experience. Claims payment statistics from brokers, adjusted to account for valid disputes, provide benchmarks for payments and allow the classification of reinsurance markets based on past experience within lines of business and geographic location.

Indicators of counterparty stress, which should also be considered within strict guidelines, include the level of losses/exposures versus capitalization, delays in settlements, increasing financial and operational leverage and significant declines in market measures such as share price and widening credit default swap spreads.

Internal security guidelines should be constantly assessed to determine if they are appropriate given market conditions and the nature of underlying risks.

Diversify

Diversification of reinsurance counterparties becomes more important under Solvency II as it can materially reduce the capital level required by the new regime. While it can mitigate some of the adverse impact, however, diversification cannot and is not meant to protect against major industry-wide losses, such as the financial crisis that began in 2007. Instead, diversification limits the risk related to any single counterparty.

Concentrating business with one counterparty will not likely provide sufficient rewards in terms of rates or simplicity to justify the additional risk. Broad diversification across several counterparties with largely uncorrelated results will limit the risk of a domino effect in the event of a large systemic loss event.

This risk cannot be eliminated, however, even with diversified exposure. As catastrophe and financial risk is disaggregated and spread throughout our industry, nearly every reinsurer has some exposure to major risks and perils and the counterparties on any given program will likely have correlated exposures. This can be partially mitigated by a second level of diversification across market platforms (Bermuda, Lloyd’s, Europe, Asia-Pacific, etc.).

Monitor

Cedents should establish and maintain global credit exposure monitoring platforms to be used in conjunction with their underwriting and other risk monitoring and management. Systems should enable immediate grasp of the current organization-wide risk exposure against a specific counterparty. Data management is thus critical in managing credit, insurance and investment risks as it allows the measurement of the aggregation and correlation of risks.

Data systems should also allow stress-testing by allowing parameters and counterparty credit positions to vary, and by incorporating contractual relationships (capital and credit rating-triggered provisions, etc.). Stress tests should include systemic crises such as major catastrophe losses, asset market turmoil and the evaporation of retrocession capacity.

We know that risk models based on past data can lead us to underestimate the probability of extreme outcomes, and we cannot assume that we have managed the risk simply by arriving at a quantitative representation. We also need strong qualitative skills. No counterparty should be accepted without a comprehensive review of its financials, resources and people. Equally important is cedents’ diligence in remaining informed about the counterparty’s current status and health. A team of savvy and critically minded staff should be charged with this task. This team has to rely on comprehensive, well-structured data - presupposing strong back-office management (or the assistance of a leading intermediary). This team should report directly to the chief risk officer or the board of directors, tying ceded reinsurance with premium debtor and investment credit risk monitoring.

Notes:

[3] EIOPA, Report on the Fifth Quantitative Impact Study (QIS5) for Solvency II, March 14, 2011.

[4] CEIOPS, QIS5 Technical Specifications, July 5, 2010.

[5] Bank for International Settlements, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, December 2010.

 

[6] EIOPA, Report on the Fifth Quantitative Impact Study (QIS5) for Solvency II, March 14, 2011.

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