October 18th, 2011

Solvency II: Counterparty Default Risk Management

Posted at 1:00 AM ET

Whatever the final method for assessing counterparty default risk 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 as well. 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 by 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 assessed constantly 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 likely will not 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. However, this risk cannot be eliminated, 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, such as Bermuda, Lloyd’s, Europe or Asia-Pacific.

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. They should also incorporate contractual relationships, such as capital and credit rating-triggered provisions for example. 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 a 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.

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