Solvency Assessment and Management: Capital Requirements Discussion Document 58 (v 3) SCR Structure Credit and Counterparty Default Risk

Solvency Assessment and Management: Capital Requirements Discussion Document 58 (v 3) SCR Structure Credit and Counterparty Default Risk EXECUTIVE SUMMARY Solvency II allows for credit and counterparty default risks in separate modules of the Basic Solvency Capital Requirement (BSCR). The discussion document deliberates why there has been a move away from this approach for asset stresses with specific reference to the appropriate treatment of risk mitigating instruments or contracts. Many of the deliberations around the structure of the module originated around the nature of the South African credit market and that the design of the counterparty default module should also be applied to a wider range of assets. The first principle which was agreed upon was that credit risk on assets should not be allowed for in different modules. In order to simplify the allowance for counterparty default risk in the SAM implementation, the Capital Requirements Task Group tested an alternative approach in SAQIS2 whereby an implicit allowance for counterparty default risk is made in each of the various market and underwriting risk sub-modules. This was also driven by the need to have a consistent treatment of assets exposed to credit risk. Those that were previously included in the counterparty default risk module were included in the credit risk sub-module of market risk, leaving only the relatively complex calculations relating to risk mitigating instruments in the counterparty default risk module. The disadvantages of this method are that There could be a degree of double counting the default risk attached to risk-mitigating contracts that covers more than one risk Having instruments to the same counterparty residing in different modules makes it difficult to apply CSAs and netting agreements that are in place There is no explicit allocation to counterparty default risk anymore and similarly the various market and underwriting risk modules do not reflect a pure view of the single risk but include a portion of default risk. Participants noted that risk mitigation converts the underlying risk exposure to a degree of credit risk exposure. This approach complicates the management of credit risk exposures as it is spread across a range of modules. The calibration of the allowance for counterparty default risk would require significant adjustment for this type of calculation as the implied concentration risk component will be over-stated (as there are a relatively smaller number of counterparties per submodule) The main advantages of this approach are that: it supports the view that counterparty default risk relating to risk mitigating instruments is mainly driven by extreme events in the risks it is intended to mitigate, and

that the counterparty default risk associated with these risk mitigating contracts are correlated with other risk types using the aggregation structure of the underlying risk types. The Solvency II consultation papers have, however, acknowledged that the prescribed formulae associated with their approach are computationally burdensome and have therefore proposed simplifications that are allowed if the result of the counterparty default module is less than 20% of the total SCR. It is the Capital Requirements Task Group s view that these simplifications can reduce the complexity in the standard formula significantly and that, in terms of complexity, these simplifications are no more complex than the approach tested in SAQIS2. In addition this would remove any concerns with doublecounting recoverables/collateral if risk mitigating instruments affect more than one module and as such an amended version of this approach was re-considered. Even with such a simplification, the SCR would require at least two additional rounds of calculation. For all other assets which contribute to credit risk exposure the Solvency II structure applies either a credit shock within the market risk module (which incorporates all factors that could changes the credit spread vs the risk-free rate) or a counterparty default shock to be applied to assets where the former approach would not result in a shock (a probability of default/loss-given-default approach is used for these exposures). Although there is no consensus yet on the ultimate approach to be adopted in the stress itself, a strong preference has been expressed not to separate credit risk exposure into different modules/sub-modules. The Capital Requirements Task Group recommends the following structure: All credit risk exposures (including those relating to the basic exposure relating to risk mitigating instruments) are included in an appropriately calibrated module of the BSCR. The working assumption is that this would be a sub-module of market risk, as this should be correlated with credit markets and should not require any diversification effects with other modules that are different to other market risk. Any additional credit risk exposure to risk mitigating instruments resulting from shocks in the SCR sub-modules are to be included as an allowance in the various sub-modules via a re-calculation of the counterparty default component following a stress. 1. INTRODUCTION AND PURPOSE The Solvency II Level I Directive distinguishes between counterparty default risk, spread risk and market risk concentrations and refers to these risks collectively as credit risk. It furthermore clearly sets out the structure of the standard formula for the Solvency Capital Requirement (SCR), in which counterparty default risk is included as one of the main modules in the Basic Solvency Capital Requirement (BSCR) while spread risk and market risk concentrations are addressed as sub-modules of the market risk module. The Directive provides some examples of types of credit exposures that should be allowed for in either the counterparty default or spread modules, but some clarification of the exact split would have to be addressed in the Level II Implementation Measures. The Directive does, however, make it clear that all credit exposures should be addressed in either the counterparty default module or the spread and concentration risk modules. The method for calculating the counterparty default risk module recommended by the CEIOPS consultation papers and tested in QIS5, involved very sophisticated and onerous calculations. The industry feedback suggested that the counterparty default risk module was Page 2 of 10

very onerous and the effort disproportionate, given the relatively small contribution of the counterparty default risk module to the total SCR. During the SAQIS1 exercise, the structure employed was similar to that used in EIOPA s QIS5 exercise. In addition, an alternative to the spread risk sub-module of market risk was tested similar to the approach adopted by OSFI (Canadian approach). This latter approach was more consistent with the approach in the counterparty default module and illustrated how the potential alignment between the credit risk exposure calculations in the SCR. Industry feedback was consistent with that from EIOPA s QIS5 exercise. Some participants believed that the Canadian approach is more suitable to the South African market whilst others believed the Solvency II approach was more appropriate, save for the calibration issues related to international credit ratings. The latter is expanded on in DD99. Based on this industry feedback and the desire to simplify the SAM implementation where possible and appropriate, the SAQIS2 technical specifications aimed to simplify the requirements relating to the credit risk associated with risk mitigating instruments. This was done by removing the counterparty default risk module and replacing it with impairments in each of the market risk and underwriting modules where the risk mitigating effects of the various counterparties would have been captured. This meant that the counterparty default risk was not quantified separately. This change tested in SAQIS2 was a material deviation from the Solvency II structure, with the main aim being to simplify the calculation. At the time, there were no other fundamental or principle based reasons for deviating from the Solvency II structure. On further investigation, the working group is now of the opinion that the simplifications already allowed for in Solvency II s QIS5 are no more burdensome than the formulae set out in SAQIS2. For other assets, insurers were asked to distinguish between liquid and illiquid assets and stress these accordingly. The absence of a single standard of classification that could be applied across the market for the purposes of a standard formula resulted in stresses being applied inconsistently between market participants. In response to this, the SAQIS3 specification was amended to have a single approach as the default, but also test the feasibility of an industry standard used to distinguish between assets. The purpose of this discussion document is to consider the merits of allowing for counterparty default risk implicitly in the various market- and underwriting risk sub-modules, as opposed to following the Solvency II approach. This discussion document also considers the relative calculation burden of the SAQIS2 approach compared to the simplification already allowed for in Solvency II s QIS5. In addition the discussion will also discuss the merits of having allowance for credit risk in a single module as opposed to separate modules/sub-modules. Any detail regarding the formulae and calibrations of the counterparty default risk module, as well as the aggregation structure is outside the scope of this document. 2. INTERNATIONAL STANDARDS: IAIS ICPs ICP 17.7.1 Types of risk to be addressed Page 3 of 10

The supervisor should address all relevant and material categories of risk - including as a minimum underwriting risk, credit risk, market risk, operational risk and liquidity risk. This should include any significant risk concentrations, for example, to economic risk factors, market sectors or individual counterparties, taking into account both direct and indirect exposures and the potential for exposures in related areas to become more correlated under stressed circumstances. ICP 17.7.2 Dependencies and interrelations between risks The assessment of the overall risk that an insurer is exposed to should address the dependencies and interrelationships between risk categories (for example, between underwriting risk and market risk) as well as within a risk category (for example, between equity risk and interest rate risk). This should include an assessment of potential reinforcing effects between different risk types as well as potential second order effects, i.e. indirect effects to an insurer s exposure caused by an adverse event or a change in economic or financial market conditions.47 It should also consider that dependencies between different risks may vary as general market conditions change and may significantly increase during periods of stress or when extreme events occur. Wrong way risk, which is defined as the risk that occurs when exposure to counterparties, such as financial guarantors, is adversely correlated to the credit quality of those counterparties, should also be considered as a potential source of significant loss e.g. in connection with derivative transactions. Where the determination of an overall capital requirement takes into account diversification effects between different risk types, the insurer should be able to explain the allowance for these effects and ensure that it considers how dependencies may increase under stressed circumstances. This discussion document deals with the structure that would be most suitable to allow for these second order effects. ICP 17.7.3 Allowance for risk mitigation Any allowance for reinsurance in determining regulatory capital requirements should consider the possibility of breakdown in the effectiveness of the risk transfer and the security of the reinsurance counterparty and any measures used to reduce the reinsurance counterparty exposure. Similar considerations would also apply for other risk mitigants, for example derivatives. This discussion document deals with the structure that would best capture the credit risk associated with risk mitigating instruments/contracts. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) The Directive requires that an explicit allowance be made for counterparty default risk. This is specified separately from the allowances for spread risk and market risk concentrations. It requires that counterparty default risk module form part of the Basic Solvency Capital Requirement and that the spread risk and market risk concentration sub-modules form part of the market risk module. This is evident from the following extracts form the Directive: Article 104 Page 4 of 10

Design of the Basic Solvency Capital Requirement 1. The Basic Solvency Capital Requirement shall comprise individual risk modules, which are aggregated in accordance with point 1 of Annex IV. It shall consist of at least the following risk modules: (a) non-life underwriting risk; (b) life underwriting risk; (c) health underwriting risk; (d) market risk; (e) counterparty default risk. [..] Article 105 Calculation of the Basic Solvency Capital Requirement [..] 5. The market risk module shall reflect the risk arising from the level or volatility of market prices of financial instruments which have an impact upon the value of the assets and liabilities of the undertaking. It shall properly reflect the structural mismatch between assets and liabilities, in particular with respect to the duration thereof. It shall be calculated, in accordance with point 4 of Annex IV, as a combination of the capital requirements for at least the following sub-modules: (a) [..] (d) the sensitivity of the values of assets, liabilities and financial instruments to changes in the level or in the volatility of credit spreads over the risk-free interest rate term structure (spread risk); (e) [..] (f) additional risks to an insurance or reinsurance undertaking stemming either from lack of diversification in the asset portfolio or from large exposure to default risk by a single issuer of securities or a group of related issuers (market risk concentrations). It should be noted that an earlier definition of credit risk does not distinguish between these components: Article 13 - Definitions For the purposes of this Directive, the following definitions shall apply: [ ] (32) credit risk means the risk of loss, or of adverse change in the financial situation, resulting from fluctuations in the credit standing of issuers of securities, counterparties and any debtors to which insurance and reinsurance undertakings are exposed, in the form of counterparty default risk, or spread risk, or market risk concentrations; [ ] 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE No differences. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) Page 5 of 10

3.1 CEIOPS CPs (consultation papers) CEIOPS-DOC-23/09 - Level 2 Implementing Measures on Solvency II: SCR standard formula - Counterparty default risk module (former CP 28 and 51) Both the CP and QIS5 distinguish between type 1 and 2 exposures, for which different formulae for calculating counterparty default risk are provided. The detail of these formulae is outside the scope of this document. The areas of concern in this discussion document are around the aspects of these formulae that makes the calculation burdensome. This relates to type 1 exposures, more specifically risk mitigating contracts such as derivatives and reinsurance. As a high level overview, the calculation of the counterparty default risk in respect of such risk mitigating contracts is based on Probability of Default (PD) and Loss Given Default (LGD) calculations. The onerous part of this calculation relates to the LGD that requires the Risk Mitigating effect (RM) of these contracts to be calculated as the difference between two hypothetical capital requirements, one with and one without the benefit from the risk mitigating contract. Furthermore, this needs to be done separately for each independent counterparty. An insurer with numerous risk mitigating contracts in place would therefore have to do numerous SCR calculations simply to calculate the counterparty default risk module. The CP acknowledges these practical challenges and both the CP and QIS5 present acceptable simplifications as an alternative where counterparty default risk is not a material portion (less than 20%) of the SCR. The simplification that addresses most of the calculation burden is in relation to the number of counterparties. It specifies that instead of performing the above mentioned calculations separately for each independent counterparty, such counterparties be grouped in disjoint subsets that are then treated as single counterparties for the purpose of the above mentioned calculations. In order to derive a probability of default for the subset, the highest probability of default of the counterparties in the subset is used. This calculation would always be conservative, as it ignores the diversification benefit between the independent counterparties within each subset. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT There are several available approaches in respect of how counterparty default risk can be addressed in the SCR structure. The alternatives considered are: 1. The approach tested in SAQIS2 and SAQIS3; 2. The approach followed by Solvency II ; 3. An amended Solvency II approach; 4. An amended approach based on SAQIS3. The approach tested in SAQIS2 was to remove counterparty default risk as a separate module. Instead, the risk mitigating effect from risk mitigating contracts such as reinsurance and derivatives was reduced / impaired with a counterparty default risk adjustment in each of the relevant market and underwriting risk modules. Allowances for default exposures to other types of counterparties that are not considered to be risk mitigating contracts, was moved to the spread / credit default risk sub-module in the market risk module. Page 6 of 10

The amendment to the Solvency II approach uses a single module to capture all forms of credit risk, but follows a more generalised approach relating to risk mitigation (allowing grouping of counterparties). The decision to include the model in either the BSCR or as submodule of market risk will be driven by the targeted diversification benefit. This will be discussed in DD111. This approach would still follow Solvency II in that the credit risk charge resulting from risk mitigating instruments or contracts is based on the impact on the SCR, resulting in a before and after calculation for each exposure (or in this case group of exposures). This means the SCR would require re-calculation based on the number of exposures/groups. The amended SAQIS3 approach is as follows: 1. Include all credit exposures on the base balance sheet in a single sub-module: This would mean that type 1 exposures in the counterparty default component of the credit risk sub-module would include the base case exposures resulting from risk mitigating contracts. 2. Take the difference between: a) the counterparty default risk assessment following the specific stress envisaged within the specific module (e.g. equity stress or mortality stress) for all instruments to which the company is exposed (i.e. both those providing risk mitigating benefits and those unaffected by the specific event), and b) the base counterparty default risk assessment (i.e. prior to the stress within the module being considered). c) it is important to note that the full counterparty default risk is assessed in each of a) and b) but there is no re-calculation of the SCR to arrive at a), merely a re-calculation of the exposure following a stress. 3. The difference between these two events should then be added to the specific submodule in question (prior to aggregation) to reflect the impact of counterparty default on the risk mitigating instruments while the counterparty default risk charge on the base remains in the in the credit risk module. This differs from the approach followed in SAQIS2 and SAQIS3 in the way that the base case is allowed for and removes the need to associate specific risk mitigating contracts/instruments with specific sub-modules. The counterparty default risk assessment would be re-performed based on the number of sub-modules. 6.1 Discussion of inherent advantages and disadvantages of each approach SAQIS2 Approach The advantage of the SAQIS2 approach is that it is less burdensome than the sophisticated version of the Solvency II approach. The reason being that the Loss Given Default does not require a full SCR calculation, but is instead dependant only the risk mitigating effect of a specific risk module. The disadvantages include: The allowance for counterparty default risk is now implicit and not explicitly visible in the SCR structure There could be a degree of double counting the default risk attached to risk-mitigating contracts that covers more than one risk, e.g. o Reinsurance contracts that cover both mortality and lapse risk would attract default risk impairment in both the mortality and lapse modules. Page 7 of 10

It is a deviation from Solvency II without a fundamental justification for why it would be more appropriate given South African circumstances. The only justification being practicality. It is not necessarily less cumbersome to calculate than the simplifications already allowed for under Solvency II. Not clear how to assess the effect of risk mitigation where risk mitigating contracts provide protection under more than one insurance or market risks. The calibration would require significant adaptation as the calibration currently employed was based on a group of credit exposures. When applied to a single submodule, the number of exposures decreases significantly, increasing the concentration component of the calibration. If this approach were to be adopted, significant effort would be required to re-calibrate the associated capital charges so as to adapt the concentration risk component of this charge. Solvency II approach Using the Solvency II approach for SAM has the following advantages: Consistency with Solvency II Explicit allowance for counterparty default risk Underwriting and market modules are pure, i.e. it does not include a default risk component Simplifications allowed for under Solvency II are not overly cumbersome. The disadvantages include: Reliance on classification to determine capital requirement which may result in significant diversified differences depending on whether instrument are included in spread risk (sub-module of market risk) or counterparty default risk module. This is also true of the QIS2 approach. Cumbersome calculations required by the sophisticated version of the standard formula (as opposed to the simplifications allowed). Adapted Solvency II approach 1 The advantages of this approach are similar to the Solvency II approach. The amendments should remove some of the disadvantages of the Solvency II approach, mainly relating to the number of times the SCR would need to be re-calculated. There would still be some reliance on classification, although this would be limited to the difference as calculated within the module similar diversification effects would be applied. This may yet be removed if a single capital requirement calculation is used for all forms of credit risk or at least for instruments with similar liquidity features. This paragraph should be read in conjunction with DD 111. Disadvantage The disadvantage of using a single module for all credit risk is that the current counterparty default module allows for some concentration risk. This means that either the module would need to be recalibrated so as reduce this impact or that only some of the assets in this module would require inclusion in the concentration risk sub-module. The need to calculate the SCR at least twice to determine the diversified risk mitigating impact. Having single correlation factor between credit and the other market risks may not capture the relationships between these risks adequately. Adapted SAQIS3 approach Page 8 of 10

Advantages This method addresses both the internal credit specific aggregation concerns (concentrations and level of diversification) It retains the appropriate overall (all risk types) aggregation methodology of the BSCR, hence there isn t a need to re-calibrate the correlation matrix. Explicit allowance for counterparty default risk Disadvantages The calculation could be cumbersome due the need to calculate the credit default risk sub-module several times.. Credit risk being captured in more than one sub-module. The default risk impairments within each sub-module assume 100% correlation between the default event and the risk of the sub-module. This is not considered implausible. The calibration of the counterparty default module was not designed with this application in mind and the inflection point of the formulae due to the relative credit quality of counterparties changing makes for anomalies. This can be addressed by either not allowing the inflection point to change the quality of the credit distribution or by removing it altogether, but Some re-calibration effort is needed to ensure that this work around does not have unintended consequences. 6.2 Impact of the approaches on EU 3 rd country equivalence Keeping the Solvency II approach would not impact on the EU 3 rd country equivalence. It is not clear whether the SAQIS2 approach or the amended SAQIS3 approach would have an impact thereon, but there is no reason to believe that it will. 6.3 Conclusions on preferred approach Solvency II allows for credit and counterparty default risks in separate modules of the Basic Solvency Capital Requirement (BSCR). The working group was unanimous in that all direct asset stresses (i.e. excluding risk mitigating instruments) should be included in a single module forming part of the market risk module. (This module may or may not have a number of components so as to calibrate appropriate stresses for different types of asset.) The main reason for this approach is to reduce the impact that classification of assets may have on the capital requirement associated with it, given that separate modules would reduce capital requirements through diversification. Similarly, consideration was given to the counterparty default charge on risk mitigating instruments reverting to the Solvency II approach. The calculation thereof may be computationally burdensome, given that it requires a recalculation of a hypothetical Solvency Capital Requirement both with and without allowing for the benefits of risk mitigating contracts. These calculations also need to be done separately per independent counterparty. The QIS1 exercise indicated that in general the magnitude of these capital requirements are proportionally small in the context of the total Solvency Capital Requirement (SCR) and the relative complexity of the calculations. The approach followed in SAQIS2/SAQIS3 was discounted mainly due to the potential double-counting of the recoverable and collateral relating risk mitigating instruments if these are allowed for in multiple sub-modules, whilst restricting their impact to a single sub-module may overstate capital requirements. In addition, the Page 9 of 10

approach which applies the current calibration per sub-module would require significant re-calibration work. The amended SAQIS2/SAQIS3 approach would address most of the disadvantages of the SAQIS3 approach. The main drawback is that it has some portions of credit risk (that associated with the benefit of risk mitigating contracts) reflected with submodules as opposed to in a single module. The approach supports the view of additional credit risk relating to these instruments being driven by underlying risk factors as opposed to credit market volatility. In principle, the approach is only different to Solvency II in the order in which counterparty default charges and diversification is applied. (This can be shown numerically). The task group preferred the latter approach as it does not introduce structural changes to other aspects of the SAM framework. Limited feedback was provided on the practicability of the amended Solvency II vs the amended SAQIS2/SAQIS3 approach, but the consensus was that the latter is more practicable. A practical consideration relates to the formulae calculating the counterparty default risk introducing an inflection point. The calibration impact would be considered in DD111, but the preferred approach to resolving this issue is to not have the higher charge applied. (The instances where participants changed between regimes is where the average credit quality of counterparties improved following a stress.) 7. RECOMMENDATION The recommendation is to allow for all credit and counterparty default risk, whether these relate to investment assets or risk mitigating contracts in a single module as far as possible. The working assumption is that this would be a sub-module of market risk. (Strong evidence as to why this is not appropriate would be required given that the treatment of additional credit risk from risk mitigating instruments following a shock event.) Additional credit risk exposure to risk mitigating contracts/instruments resulting from shocks should be included in the sub-modules driving these shocks prior to diversifying along with the underlying risk in BSCR calculations. Counterparties relating to risk mitigating instruments/contracts may be grouped provided the lowest credit rating is used for the group in question. The calibration of the modules considered 8. QUESTIONS TO INDUSTRY 1. Would the alternative approach to allowing for the credit risk charge relating to counterparty default risk be a more practicable solution than the amended Solvency II approach? Page 10 of 10