A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market...

A Paradigm ShiftBased on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence

Casualty Actuarial SocietySeminar on Ratemaking 2003

Athula Alwis, ACAS, American ReChris Steinbach, FCAS, Swiss Re


IntroductionThe convergence of the insurance and financial markets changes the way we need to look at credit and surety:

Products have become more sophisticated, requiring new risk management procedures (both risk quantification and exposure management)Insureds have become more sophisticated, dramatically increasing the risk of anti-selection and requiring new pricing methodsRegulators, rating agencies and investors have become more vocal about their concerns


The spectrum of products is growing

Contract surety

Commercial surety

Credit insurance

Financial guaranty

Credit derivatives

Structured credit solutions

The possibility that the risk transfer being sold in the market is a mixture of these products is increasingly high.


Clients are getting more sophisticated

Example:

Eastern Power sells $100mm of electricity to Western Power, payable in advance.Western Power then sells the same electricity back to Eastern Power for $105mm, payable in arrears and insured with a power delivery bond.Combined, the two form a $100mm loan from Western to Eastern at 5% interest with the credit risk stripped out.


Market forces are driving evolution

Insureds increasingly are unable to purchase enough credit protection through traditional channels, driving them to the new & non-traditional productsInsurers generally are unable to adequately monitor credit aggregations across all of their products, resulting in them putting out too much total capacityDifferences between insurance and financial markets pricing create arbitrage opportunities


Insurers are being forced to change

Insurers originally welcomed the new products because they wanted top-line growth, and they tried tapping into the financial market’s revenuesInsurers have since learned that credit is a catastrophe prone risk, and it must be managed accordinglyBoth insurers and insureds have learned that insurance is very different from finance, even if the risks look similarRegulators, rating agencies and investors have begun demanding greater transparency and better quantification & control of credit risk exposures


Insurance Pricing Theory

Surety is considered a Property line of business:Rates are a function of the exposure (bond) size and classification Usually based on loss experience

Weaknesses:Does not adequately capture the credit cycleDoes not adequately reflect changes in credit qualityDoes not adequately differentiate between risks


Financial Market Pricing Theory

Surety Policy E[L] = (Financial Instrument E[L], )

= Probability of Loss as a Surety Product / Probability of Default as a Financial Instrument

– Financial Instrument E[L] = Notional Amount x Default Rate x (1 – Recovery Rate) x Correlation Factor


Calculation of E(Loss) [for a single principal]

(1) Principal XYZ Inc.

(2) Credit Rating Baa3 (3) Industry Power (4) Exposure 25,000,000 (5) Duration 5

[A single payment of $25mm is due in 5 years.] (6) Moody's Default Rate 3.05% (7) Average Recovery Rate 10%

[Default value for high risk bonds]

(8) 100%[Bond is a no-recourse demand obligation.]

(9) Expected Loss 686,250 = (4) x (6) x [1 - (7)] x (8)

(10) Discount (@ 5%) 0.784 (11) PV(Expected Loss) 537,695 = (9) x (10) Correlation Factor is 1.0 because this is a single principal


Calculation of E(Loss) [for a multiple principals]

The calculations for a portfolio of primary or reinsurance risks can be achieved similarly.An advanced and more realistic method is to the calculations using a simulation modelLoss scenarios are simulated based on credit ratings while the recovery rates and the volatility around recovery rates are factored in using a beta function. Then, a correlation matrix is brought in the picture using calibrated multi-variate normal copula approach.


Risk Management Techniques

Concentration limitsOrderly exit strategyCollateral covenantsReinsuranceCredit derivativesDiversification with non-credit


Risk Management Requirements

A sophisticated inventory system, tracking both assumed and ceded exposures, in a consistent manner, for all products & investmentsA credit catastrophe model (similar to the nat-cat models)A capacity allocation/management process (similar to the nat-cat processes)Integration of the risk management and pricing systemsUnderstanding why the insured is buying protection


Conclusion

The traditional insurance methods for evaluating and managing surety risks have become out-dated. Insurance companies who do not change are at risk of being anti-selected against. The consequences of writing these product with the old methods are severe.

We strongly believe that following the lead of financial markets could help the surety industry quantify and manage Credit & Surety risks more effectively and more efficiently. This will ensure the long-term availability of sufficient capital, and thus capacity, for this line of business.


Question and Answer


Contact Information

Athula Alwis: [email protected]

Chris Steinbach: [email protected]

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market...

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