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Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009
Appendix 3
Use of credit ratings in the future �Solvency II� European
Insurance regulatory framework
The future �Solvency II� European Insurance
regulatory framework is work in progress.
The Solvency II Directive Proposal is principles-based and does
not refer directly or indirectly to rating agencies.
However, the Committee of European Insurance and Occupational
Pensions Supervisors (CEIOPS) in cooperation with the European
Commission is already working on the future implementing measures
through its Quantitative Impact Studies.
Information about the possible use of credit ratings in this
future framework can be found in the QIS4 Technical specifications
published on 31 March 2008.45 Please note that this is not a final
text.
In the latest draft, credit ratings are used
to calculate the Solvency Capital requirement (SCR) which is one
of the two capital requirements introduced in the Solvency II
framework.
The MCR (Minimum Capital Requirement) and technical provisions do
not use credit ratings.
The SCR could be calculated in two ways, either through an
internal model or through a standard formula.
The use of credit ratings in internal models is not mentioned
either in the Directive Proposal nor in QIS4 � the Directive
Proposal leaves great freedom to firms in the way they elaborate
their model.
QIS4 details the standard formula.
In the SCR calculated through the standard formula, it is
suggested that credit ratings be used to calculate Market risk and
Counterparty default risk.
In the Market risk, credit ratings would be
used to compute the spread risk and concentration risk.
Credit ratings are also likely to be used to assess the adequate
credit quality of the providers of financial risk mitigation, in
order to guarantee with appropriate certainty that the insurer
will receive the protection in the cases specified by the
contracting parties (only financial protection provided by
entities rated BBB or better is likely to be considered in the
assessment of SCR).
The following text summarisies some of the key features of the
framework that are being suggested in the QIS4 Technical
specifications published on 31 March.
1. Use
of credit rating in the SCR market risk module of the standard
formula
Spread risk:
This module is intended to be applicable to bonds, to all tranches
of structured credit products like asset-backed securities and
collateralised debt obligations, and would further cover credit
derivatives eg credit default swaps (CDS), total return swaps (TRS),
credit linked notes (CLN), that are not held as part of a
recognised risk mitigation policy.
It would exclude government bonds (borrowings by the national
government, or guaranteed by the national government, of an OECD
or EEA state, issued in the currency of the government) as well as
assets allocated to policies where the policyholders bear the
investment risk.
For the purposes of determining the SCR for spread risk, companies
would need to assume the more onerous (in aggregate) of a rise or
fall in credit spreads.
Concentration risk:
The definition of market risk concentrations would be restricted
to the risk regarding the accumulation of exposures with the same
counterparty.
It would not include other types of concentrations (eg
geographical area, industry sector etc.).
It has been suggested that the following items be exempted from
the application of this module:
� government bonds( borrowings by the
national government, or guaranteed by the national government, of
an OECD or EEA state, issued in the currency of the government);
� bank deposits with a term of less than 3 months terms, of up to
3 million Euros, in a bank that has a minimum credit rating of AA;
and
� assets allocated to policies where the policyholders bear the
investment risk.
Risk exposures in assets would be grouped according to the
counterparties involved.
Where an undertaking had more than one exposure to a counterparty
then its net exposure at default to the counterparty would be the
aggregate of those exposures at default and the rating of the
counterparty should be a weighted rating.
All entities which belong to the same group should be considered
as a single counterparty for the purposes of this sub-module.
The net exposure at default to an individual counterparty would
comprise the asset classes of equity and fixed income, including
hybrid instruments junior debt, and CDO tranches.
Financial derivatives on equity and defaultable bonds should be
properly attributed (via their �delta�) to the net exposure, ie an
equity put option reduces the equity exposure to the underlying
�name� and a single-name CDS (�protection bought�) would reduce
the fixedincome exposure to the underlying �name�.
The exposure to the default of the counterparty of the option or
the CDS would not be treated in this module, but in the
counterparty default risk module.
Also, collateral securitising bonds should be taken into
account.
Similarly, a lookthrough approach would need to be applied to
assets representing reinsurers' funds withheld by a counterparty.
Exposures via investment funds or such entities whose activity is
mainly the holding and management of an insurer�s own investment
need to be considered on a look-through basis.
The same would hold for CDO tranches and similar investments
embedded in �structured products.�
The module would deliver as output the Capital charge for market
concentration risk (Mktconc), either including or not the risk
absorbing effect of future profit sharing.
The calculation would be performed in three
steps:
(a) an excess exposure would be calculated in reference to a
concentration threshold, depending on the rating of a
counterparty.
(b) the risk concentration charge per �name� would be calculated
depending on this excess exposure by counterparty, the credit
rating of each counterparty, and the amount of total assets where
the insurer bears the investment risk.
(This stage also would take into account the overall impact of a
stressed scenario on the liability side for policies where the
policyholders bear the investment risk with embedded options and
guarantees.)
(c) the total capital requirement for market risk concentrations
would be determined assuming independence between the requirements
for each counterparty i.
2.
Use of credit rating for counterparty default risk in the SCR
Counterparty risk module of the standard formula
Counterparty default risk is the risk of
possible losses due to unexpected default, or deterioration in the
credit standing of the counterparties or debtors in relation to
risk mitigating contracts, such as reinsurance arrangements,
securitisations and derivatives, and receivables from
intermediaries, as well as any other credit exposures which would
not be covered in the spread risk sub-module.
For each counterparty, the counterparty
default risk module should take account of the overall
counterparty risk exposure of the insurance or reinsurance
undertaking concerned to that counterparty, irrespective of the
legal form of its contractual obligations to that undertaking.
The main inputs of the counterparty default risk module would be
the estimated loss-given-default (LGD) of an exposure and the
probability of default (PD) of the counterparty.
In relation to a counterparty of reinsurance contracts (or an
SPV), the loss given default would be linked to the best estimate
of recoverables from the reinsurance contract, the SCR for
underwriting risks including or not the risk mitigating effect of
the reinsurance contract and the collateral covering the loss in
relation to the counterparty.
Collateral would not be allowed to be taken into account in the
above calculation if it were held by the counterparty itself.
If the collateral bore any default risk, it should be included in
the module calculation like receivables from intermediaries and
other credit exposures.
A factor of 50 percent would take into account the fact that even
in case of default the reinsurer will usually be able to meet a
larger part of its obligations.
In relation to a counterparty of financial derivatives, the loss
given default would be defined with the same method but by taking
into account the Market value of the financial derivative instead
of the Recoverables and the SCR for Market risks instead of the
SCR for underwriting risks.
In relation to the intermediary risk and any other credit
exposures, the loss given default would represent the best
estimate of the credit to intermediaries and any other credit
exposures respectively.
The overall loss-given default in relation to each counterparty
would be the sum of the lossesgiven- default for reinsurance and
SPVs, financial derivatives, and intermediary risk and other
credit exposures.
A probability of default (PD) of the counterparty estimate is
derived from external ratings according to a defined table.
To read the paper with all the details:
www.bis.org/publ/joint22.pdf?noframes=1
Basel Committee on Banking Supervision, The Joint Forum
Stocktaking on the use of credit ratings - June 2009 Part 1
Stocktaking on the use of credit ratings - June 2009 Part 2
Stocktaking on the use of credit ratings - June 2009 Part 3
Stocktaking on the use of credit ratings - June 2009 Part 4
Stocktaking on the use of credit ratings - June 2009 Part 5
Stocktaking on the use of credit ratings - June 2009 Part 6
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