QIS3 Calibration of the credit risk

CEIOPS- FS-23/07 Q Q I I S S 3 3 C C a a l l i i b b r r a a t t i i o o n n o o f f t t h h e e c c r r e e d d i i t t r r i i s s k k April 2007 CEIOPS e.V. - Westhafenplatz 1 – 60327 Frankfurt am Main – Germany – Tel. + 49 69-951119-20 – Fax. + 49 69-951119-19 email: secretariat@ceiops.org ; Website: www.ceiops.org Table of content Introduction ............................................................. 3 Spread risk ............................................................... 5 Counterparty default risk........................................ 12 Concentration risk .................................................. 22 Examples ................................................................ 33 2 1. Section 1 Introduction 1.1 This paper

deals with the calibration of credit risk within the SCR standard formula. The QIS2 credit risk module is replaced with separate modules for counterparty default risk (SCR def ), spread risk (Mkt sp ) and an additional, explicit recognition of the risk arising from concentrations (Mkt conc ). The spread risk and concentration risk modules will fall under the market risk category. This broadly reflects the approach envisaged by some of CEIOPS' stakeholders, and also has the advantage that it is more closely aligned with requirements in the banking sector. 1.2 Spread risk is the part of risk originating from financial instruments that is explained by the volatility of credit spreads over the risk-free interest rate term structure. ƒ The spread risk module includes the systematic part of migration and default risk implicitly via the movements in credit spreads. Credit indices rebalance on a monthly basis and, consequently, the change of their constituents, due to downgrades or upgrades, has a monthly frequency as well. Hence, the impact of intra-month downgrades/upgrades has already been reflected in the movements of credit spreads. However, further consideration may need to be given to the allowance made in the calibration for potential credit migrations and defaults. ƒ The spread risk module assumes well diversified portfolios. The concentration risk module captures the specific or idiosyncratic risk components. ƒ The spread risk module includes credit derivatives (e.g. credit default swaps). The module takes account of exposures to the originator of the reference, or underlying, obligation of the derivative contract. The 1 associated default risk on the protection seller will be part of the counterparty default risk module. 1.3 The counterparty default risk module deals with the risk of default of a counterparty to risk mitigating contracts like reinsurance and financial derivatives. ƒ The counterparty default risk module includes concentration risks. 1 The protection seller will be obligated to pay for the loss incurred by creditors of the reference obligation in the event of its default. 3 The concentration in both reinsurance and financial derivatives exposures are calculated via the Herfindahl index. ƒ The module includes counterparty risk arising from financial derivatives (e.g. interest rate swaps and credit default swaps). 1.4 Market risk concentrations present an additional risk to an insurer because of lack of diversification. ƒ Additional volatility that exists in concentrated asset portfolios; and ƒ Additional specific or idiosyncratic default and migration risks. 1.5 Section 2...

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