Credit Quality StepsA Practical Guide

Zante Kilian

PwC

zante.kilian@pwc.com

AGENDA

1. Background

2. Prudential Standard Guidance (Pillar 1 & 2)

3. Alternative Approaches

4. Live Poll

5. Considerations

6. Examples

7. Conclusion

8. Questions

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1. BACKGROUND

Credit Quality Steps (CQS)

• SAM Solvency Capital Requirement calculations (FSI’s)

• Shock counterparties’ exposure for default in these modules

• Counterparties are ranked according to CQS

• Shocks dependent on CQS ranking

• Considerations/ overlaps in Governance (GOI’s)

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SCR

Market Risk

Spread & Default

Concentration

Life Non-Life

Premium & Reserve Risk

CAT Risk

BSCR

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§9.9

• “The calculation of the capital requirements for spread risk and default risk relies on the assignment of

credit ratings to instruments…

• The basis on which credit ratings are assigned… is through credit quality steps,

• reflect long term historic probabilities of default, rather than external credit ratings

• …allows for different external and internal ratings to be used in a consistent manner”

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2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§9.10

• “Where an insurer relies on external ratings…and there is more than one external rating available…

• historic default rates … must be assessed…”

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2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§9.12, Attachment 4

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The capital requirement for spread risk takes into account the loss given default as well as shocks

and factors to consider per counterparty …

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§9.17

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CQS Prob of Default

1 0.01%

2 0.02%

3 0.03%

4 0.06%

5 0.09%

6 0.11%

7 0.16%

8 0.22%

9 0.39%

10 0.54%

11 0.81%

12 1.39%

13 2.5%

14 5.37%

15 8.72%

16 20%

17 25%

18 30%

The default risk for type 1 (rated entities) exposures is

calculated taking into account the loss given default, fixed

gamma of 0.25 as well as the probability of default per

counterparty

LGD (prescribed)

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§9.27

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CQS Factor

1 0.1%

2 0.19%

3 0.27%

4 0.49%

5 0.68%

6 0.8%

7 1.08%

8 1.37%

9 2.06%

10 2.56%

11 3.27%

12 4.35%

13 5.68%

14 7.96%

15 10.1%

16 14.47%

17 15.38%

18 15.86%

The default risk for type 3 (cash at bank) exposures is

calculated taking into account the factor assigned to

each counterparty based on CQS

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§10.4

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“The calculation of the concentration risk capital requirement (𝑀𝑘𝑡𝑐𝑜𝑛𝑐) must be performed in three steps:

a) Calculation of excess exposures per counterparty (step 1);

b) Determination of concentration risk capital requirements per counterparty (step 2); and

c) Aggregation of concentration risk capital requirements across all counterparties (step 3)”

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§10.4

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Step 1

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4.1

§10.4

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Step 2

2. PRUDENTIAL STANDARDS - PILLAR 1

FSI 4

§Attachment 2

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• “Insurers are required to account for default risk …

• This requirement extends to recoverables from risk mitigation instruments…

• given that recoverables from eligible risk mitigation instruments must be treated as a “type 1 exposure”…

• (refer to section 9 of FSI 4.1 (Market Risk Capital Requirement)).”

2. PRUDENTIAL STANDARDS

FSI vs GOI

• Equally important and not mutually exclusive

• FSI guidance on calculations for capital (Pillar 1)

• GOI’s focus on Governance and Risk Management (Pillar 2)

• Use as guidance to inform process for FSI calculations

• Compliance with GOI automatically improves/ talks to processes for FSI’s

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2. PRUDENTIAL STANDARDS - PILLAR 2

GOI 3.3

§6.1

“An insurer must regularly perform a sufficient level of due diligence on its reinsurers

to ensure that the insurer is aware of its counterparty risk and is able to assess and

manage such risk…”

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2. PRUDENTIAL STANDARDS - PILLAR 2

GOI 3.3

§6.3

“In performing its due diligence, an insurer

must consider, among other things, the

reinsurer’s:

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Governance

Risk

Management

Controls

Claims: payment

record, future

obligations

Balance sheet

strength

Operational

capabilities

Reinsurer

due diligence

Funding

sources, liquidity

Skills &

Expertise

2. PRUDENTIAL STANDARDS - PILLAR 2

GOI 3.3

§6.2

“The level of due diligence an insurer must perform on its reinsurers must be:

a) commensurate with its level of exposure to that reinsurer;

b) not solely dependent on third-party assessments such as rating agency assessments or broker…; and

c) no less thorough even if the counterparty is a related or interrelated party of the insurer

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2. PRUDENTIAL STANDARDS - PILLAR 2

GOI 3.3

§6.5

“Where the insurer is aware that a reinsurer relies significantly on retrocessions, the insurer must also

identify and assess the financial standing of the reinsurer’s retrocessionaires”

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3. ALTERNATIVE APPROACHES

1. Alternative validated mapping of Credit Ratings to probabilities of default

• External rating ratings used, but not a 1-to- 1 mapping to the probability of default table

2. Various Credit Models

• Calculated internally, outsourced

• Validated

3. Validated Internal models

• Reliance on validated internal model of specific counterparty

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4. L IVE POLL

Q1 : What is the audience mix?

• Life Insurer

• General Insurer

• Bank

• Reinsurer

• Other

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4. L IVE POLL

Q2 : Is your organization aware of methods other than external Credit Ratings?

Yes

No

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4. L IVE POLL

Q3 : Is your organization using methods other than using external Credit Ratings?

Yes

No

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4. L IVE POLL

Q4 : Main reason for not using Alternatives as opposed to external Credit Ratings?

• We have not yet thought about alternatives

• We have not yet thought about alternatives- but will in the next 12 months

• Cost & Resources

• Credit Rating Mappings are easy

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5. CONSIDERATIONS

EXTERNAL CREDIT RATINGS

• Available for most entities

• No additional costs

• Acceptable

• Effect on SCR

ALTERNATIVE METHODS/ MODELS

• Accuracy

• Governance & Risk Management

• Independence

• Effect on SCR

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• More than one credit rating per entity depending on rating agency

• Rating agency bias

• Effect on SCR

• Spurious accuracy

• Cost and resources

• Effect on SCR

5. CONSIDERATIONS

Board approval of CQS policy (regardless of method)

Documentation- ensure consistency within group(s) and divisions (ORSA)

Compliance with GOI (3.3)

Nature Scale & Complexity

Frequency of updates

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5. CONSIDERATIONS

Sovereign downgrades

Difference in ratings (S&P vs Moody’s)

Industry consistency

Collaboration

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6. EXAMPLES

Effect of CQS on SCR

1. Effect of 3-notch improvement in CQS of main reinsurer for small insurer with significant reliance on

proportional reinsurance (NLUR CAT Risk module)

2. Effect of 3-notch improvement in CQS of main reinsurer for large insurer with no significant reliance on

proportional reinsurance (NLUR CAT Risk module)

3. Effect of 1-notch improvement in CQS of banks for a small insurer’s Market Risk Shock

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6. EXAMPLES

Example 1 Assumptions

• LoB: Property & Motor

• Premiums: R40m (property), R60m (motor)

• NAT CAT Exposure: R4bn (60% Gauteng)

• RI structure: 90% QS with one Reinsurer

• Scenario 1: CQS=8, Scenario 2: CQS= 5

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6. EXAMPLES

Example 1 Results

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Premium & Reserve

Risk: 10.6

Premium & Reserve

Risk: 10.2

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 1 Results

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Premium & Reserve

Risk: 10.6

CAT Risk: 15.5

Premium & Reserve

Risk: 10.2

CAT Risk: 11.2

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 1 Results

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Premium & Reserve

Risk: 10.6

CAT Risk: 15.5

Diversified Capital

Charge: 20.9

Premium & Reserve

Risk: 10.2

CAT Risk: 11.2

Diversified Capital

Charge: 17

15%

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 2 Assumptions

• LoB: Property & Motor

• Premiums: R400m (property), R600m (motor)

• NAT CAT Exposure: R40bn (60% Gauteng)

• RI structure: CAT XL one Reinsurer, R20m deductible

• Scenario 1: CQS=8, Scenario 2: CQS= 5

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6. EXAMPLES

Example 2 Results

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Premium & Reserve

Risk: 280

Premium & Reserve

Risk: 280

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 2 Results

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Premium & Reserve

Risk: 280

CAT Risk: 80

Premium & Reserve

Risk: 280

CAT Risk: 76

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 2 Results

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Premium & Reserve

Risk: 280

CAT Risk: 80

Diversified Capital

Charge: 310

Premium & Reserve

Risk: 280

CAT Risk: 76

Diversified Capital

Charge: 308

0.7

%

NLUR Risk Charge

Scenario 1:

CQS=8

Scenario 2:

CQS= 5

6. EXAMPLES

Example 3 Assumptions

• Insurer with a R204m asset base split as follows:

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Asset CQS scenario 1 CQS scenario 2 Amount (R’m)

Bank 1 10 9 47

Bank 2 10 9 79

Bank 3 10 9 58

Equity 1 7 7 10

Equity 2 7 7 5

Equity 3 7 7 5

6. EXAMPLES

Example 3 Results

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Spread & CP Default:

6.8

Spread & CP Default:

5.1

Market Risk Charge

Scenario 1:

CQS=10

Scenario 2:

CQS= 9

6. EXAMPLES

Example 3 Results

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Spread & CP Default:

6.8

Concentration: 14.3

Spread & CP Default:

5.1

Concentration: 5.8

Market Risk Charge

Scenario 1:

CQS=10

Scenario 2:

CQS= 9

6. EXAMPLES

Example 3 Results

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Spread & CP Default:

6.8

Concentration: 14.3

Diversified Capital

Charge: 18.7

Spread & CP Default:

5.1

Concentration: 5.8

Diversified Capital

Charge: 12.6

32%

Market Risk Charge

Scenario 1:

CQS=10

Scenario 2:

CQS= 9

7. CONCLUSION

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• Prudential Standards are principles based

• External Credit Ratings used for various reasons but possible to deviate

• Documentation and approval/ validation

• Determine unique effect of CQS on SCR

• All counterparties or significant counterparties?

• Market Risk or Underwriting Risk

• Consider cost and effort vs wider benefit on Governance and Risk Management (GOI compliance)

• Industry collaboration

THANK YOUQUESTIONS