The International Association of Insurance Supervisors (IAIS) is asking for input on the issue of how to determine credit risk charges for collateralised reinsurance as part of the latest stage of its mission to create a Risk-based Global Insurance Capital Standard.
Over the last few years the IAIS has been through a lengthy consultation process to elicit market input and feedback on an under development Risk-based Global Insurance Capital Standard (ICS).
The latest consultation document has been published today and in it the IAIS asks for some input on how the proposed capital standard should treat collateralised reinsurance arrangements.
Any risk-based capital standard needs to look closely at sources of risk and reinsurance capital and define how they qualify for credit, whether they hold risks such as counterparty or credit exposure and ultimately how they will fit within the overall insurance capital standard.
With collateralised reinsurance coverage, be that from the full collateralisation of a reinsurance contract, a catastrophe bond, or some other fully-collateralised reinsurance structure, being collateralised on a one for one basis in dollar (or whatever currency) terms, it’s questionable whether it should carry any credit or counterparty default risk at all.
At the moment, the proposal seeks to treat collateralised reinsurance using the “substitution approach” when it comes to valuing collateralised coverage for capital requirements purposes.
The IAIS explains the substitution approach:
“Whereby the protected portion of a counterparty exposure is assigned the rating category of the guarantor or protection provider, while the uncovered portion retains the rating category of the underlying counterparty. Thus only guarantees issued by or protection provided by entities with a higher rating category than the underlying counterparty will lead to reduced capital requirements.”
However, the consultation document published today notes that “some believe the ‘substitution approach’ currently applied for collateralised reinsurance is not appropriate on the basis that there would typically be little correlation between reinsurer and collateral default.”
As a result, the IAIS is considering two other mechanisms for determining credit risk charges for reinsurance exposures and arrangements, a double default or ‘haircut’ approach.
The IAIS explains the two alternative approaches:
- Under a double default approach, the Credit risk factor applied to a collateralised reinsurance exposure is based on the joint probability of both the reinsurer and the issuer of the collateral defaulting. This probability will normally be lower than both the probability of default of the reinsurer, and the probability of default of the issuer of the collateral, as the two Credit risks are unlikely to be perfectly correlated.
- Under a haircut approach, the reinsurance credit exposure is reduced by the amount of collateral, with the collateral amounts subject to “haircuts” to account for potential declines in value due to risks to which the collateral is exposed (typically Market and Credit risk).
With collateralised reinsurance and instruments such as catastrophe bonds in the ILS world, their collateral is as good as held in cash, being in highly rated, low return/risk treasuries, and held in a trust by a global custodian bank. It’s effectively as safe as you can get, other than stashing gold under the mattress perhaps.
So, the ILS product should perhaps be treated as less risky, in terms of credit or counterparty risk, than traditional reinsurance which is backed by a company and it’s balance-sheet that is making a promise to pay.
This could be beneficial for the ILS market under a new global insurance capital standard, if the collateralised reinsurance and other ILS products were treated more favourably than their traditional competitors.
The goal of a regulatory capital standard for insurers and reinsurers is to determine their capital requirements, so effectively how much they must hold. If by utilising ILS products that are fully collateralised a re/insurer can reduce its capital requirements somewhat, that would certainly be a good selling point for the ILS product.
The IAIS specifically asks:
Should the IAIS continue to explore a different approach for Credit risk from reinsurance exposures, and in particular, for collateralised reinsurance? Why or why not? If “yes”, please provide specific proposals, rationale and evidence to support the proposals.
So if the substitution approach currently in use is not sufficient, in your view, we’d encourage you to provide feedback.
Details of the consultation can be found over on the IAIS website.