2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
SFSC’s Credit risk working group update
Development of internal model
methodology for regulatory capital
(Credit Risk Only)
September 25, 2008
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Contents
1.
2.
3.
4.
5.
Introduction to working group members
Scope and criteria for credit risk capital
Summary of regulatory solvency models compared
CRWG’s draft proposal
Implementation considerations
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Introduction to credit risk working group
(CRWG)
Section 1
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
List of members of Credit Risk Working
Group (CRWG)
• Bryan Rowe, Director, Economic Capital,
SunLife Financial
• Cam MacDougall, VP, Credit Risk Management,
Manulife Financial
• David Ayers, Director Bond Investments (Risk
Management) , Great West Life
• Erik Von Schilling, Senior Manager , TD Life
• Jean- Guy Lapointe, Capital Division, OSFI
• Karim Nanji, Director, Strategic Planning, Munich Re
• Mark Austin, Vice President, RBC
• Simone Brathwaite, Principal, Oliver Wyman
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Scope and criteria for credit risk capital
Section 2
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Scope: Possible working definitions of
credit risk
Broad definition (aligned with Solvency II – includes market liquidity risk)
• Credit risk is the risk of loss or of adverse change in the financial situation
resulting from fluctuations in the price or value of securities and counterparty
debt due to:
–
–
Adverse fluctuation in credit quality of issuers, counterparties and debtors
(specific risk)
Adverse fluctuation in market liquidity (systemic risk or generic spread-widening)
Stricter definition (aligned with Basel II IRB – excludes market liquidity risk)
• Credit risk is the risk of loss or of adverse change in the financial situation
resulting from fluctuations in the credit standing of issuers, counterparties, and
any debtors
CRWG favoured the treatment of “market liquidity risk” under a separate
risk model
–
Note – “Market” liquidity risk is also referred to as generic spread risk
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Objectives of internal solvency model for
credit risk
• Consistent with over-arching principles for all risks, such as
– Confidence level
– 1 year time horizon
• Captures all material risk drivers appropriately – without
unnecessary complexity
• Relevant and useful for managing risk – incentives risk
management
• Appropriate reflection of risk mitigation techniques
• Appropriate capture of diversification and correlations
• Widely-recognized and vetted industry approach – an approach
which is compatible internationally
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Summary of regulatory solvency
models reviewed
Section 3
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
CRWG reviewed 2 regulatory frameworks
1. Basel II formula-based approach
1.
2.
Basel II approach – pillar 1: Advanced Internal Ratings Based formula-based
approaches
Credit risk capital is determined using a closed-form analytical formula:
Basel Capital = (Worst case loss – Expected Loss) x Maturity Multiplier
Capital held for default losses over
1 year time horizon
•
•
Capital held for value loss from
credit migrations over 1 year
time horizon
Advanced IRB - certain input parameters are determined internally at a transaction-level
Key advantages:
–
Widely recognized by global financial industry and Canadian regulator
–
Captures pure credit risk - loss of value due to defaults and migrations at
–
Excludes systemic risk (market liquidity risk/generic spread widening)
–
Consistent with the one-year time horizon
Key disadvantages:
–
Single factor correlations (the economy or portfolio taken as the single factor)
–
Also assumes infinite granularity and maturity multiplier cap of 5 years
–
Unclear if it will integrate well with proposed model approaches on other risks
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
…and 2. proposed Solvency II model for
credit risk
2. Proposed Solvency II approach for European insurers
•
Credit risk capital also determined using a closed form analytical approach
MVi   MV  durationi  CreditSpread  f (ratingi)
i
•
•
•
•
•
Where credit risk is expressed primarily by the volatility of credit spreads, and
Movements in credit spreads assumed to capture pure credit risk and market liquidity risk
Includes an additional explicit recognition of specific risk arising from high concentrations
Key advantages:
– A theoretically fully integrated model which captures both credit and market liquidity
risk
Disadvantages:
– Cannot be used to manage risk at transaction level (grouped by public rating)
– Theoretically fully integrated, but unclear as to whether available data can
appropriately parameterize model (e.g. not clear that data captures default risk- over 1
yr time horizon)
– Not used industry wide as sole approach – SST uses this approach in combination with
a default loss Basel II type model
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
CRWG’s preference is for a Basel II modified
approach
•
In addition to existing regulatory models – CRWG discussed the option of
using stochastic portfolio models
•
However, despite possible advantages, during discussions it was determined
that neither the insurance industry nor the regulator would be ready for this
option over the next 5-8 years
As a result CRWG is in favour of using the Basel II advanced IRB analytical
formula approach with possible enhancements to address:
– Restricted maturity under Basell II
– Assumption of infinite granularity
– Integration with other proposed risk models
•
•
Next steps:
– MAC to prioritize modifications and investigate resources to specify
model modifications
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
CRWG’s draft proposal
Section 4
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Overview of IRB formula based approach
•
•
•
•
•
The formula is based on 5 key parameters:
• PD – Probability of default
• LGD – Loss given default
• EAD – Exposure at default
• Correlation (Asset Correlation)
• Effective Maturity (similar to duration)
The capital formulas determine Basel II capital net of EL:
– Basel capital is intended to cover the unexpected loss portion of the loss
distribution, whereas balance sheet asset values are intended to cover the
expected loss portion
Under the AIRB, financial institutions provide the PD, LGD, EAD and Effective
Maturity parameters
The correlation parameter is based on standardized formulas
Relative to the Standardized approach, the IRB approaches are designed to yield a
capital benefit via lower PDs
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
The Basel II capital formula computes a capital
requirement for each holding individually . . .
Transaction
level credit
capital
=
‘Worst case’
loss1
–
Expected
loss
Transaction
level credit
capital
=
‘Worst case’
default loss
–
Expected
default loss
Capital held against loss due to default
Transaction
level credit
capital
=
‘Worst case’
Probability of
default
(PDwc)
–
Expected
Probability of
default
(PD)
x
Loss
given default2
(LGD)
x
Maturity
multiplier
Multiplier accounts for value
loss due to credit migration
x
Exposure
at
default2
(EAD)
1. ‘Worst case’ losses are those that occur for the 99.95% worst case of the economy.
2. Basel II assumes static LGD and EAD—the same values are used for the ‘worst case’ and ‘expected’ scenarios
x
Maturity
multiplier
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
. . . and sums the transaction level numbers to
generate a portfolio level capital requirement
Portfolio
level credit
capital
=
Σ
Transaction
level credit
capital
• Portfolio capital represents the aggregate ‘worst
case’ loss minus the aggregate expected loss by
summing transaction-level capital
• The Basel methodology assumes infinite granularity
in the portfolio, not capturing the effects of singlename concentration
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Implementation considerations
Section 4
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
What to expect for internal approval
•
•
•
•
OSFI will expect a rigorous validation framework to confirm the accuracy and
consistency of the Company’s internal rating system
Approval will also depend on the robustness of quantification, corporate
governance oversight, quality of documentation, and the use test
For further details - See CAR A-1 (Chapter 5) and Implementation notes for IRB
institutions on OSFI’s website
–
http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?articleid=1218
–
http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/guidelines/capital/guidelines/CAR_A1_e.pdf
For companies planning to seek approval on implementation date (2014)
–
–
–
–
–
Provide statement of intent before Oct 14, 2008
Gap analysis, implementation planning (with OSFI) before 2011
Formal application by 2012
Parallel reporting 2012-2014
Full internal model approval by 2014 (and ongoing compliance)