October 17th, 2011

Solvency II: Assessing Counterparty Default Risk

Posted at 1:00 AM ET

Counterparty default risk is one of the core components of the SCR. This module has undergone substantial change over the several quantitative impact studies, 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 (1). We expect to see additional changes that will simplify the calculation of risk.

Assessing Counterparty Default 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 (2).

Formulas for loss given default (LGD ) vary based on the type of risk-mitigating contract. For reinsurance and securitization, 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 (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 15 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, such as credit default swaps and bonds for reinsurers that have them (3).

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)(4). EIOPA and supervisors will consider a wide range of ways to simplify this module to address these issues prior to implementation.

Notes:

1 EIOPA, Report on the Fifth Quantitative Impact Study (QIS 5) for Solvency II, March 14, 2011.

2 CEIOPS, QIS 5 Technical Specifications, July 5, 2010.

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

4 EIOPA, Report on the Fifth Quantitative Impact Study (QIS 5) for Solvency II, March 14, 2011.