A Paradigm Shift Based on the paper: Credit

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

• Casualty Actuarial Society
• Seminar on Reinsurance 2003
• June 2, 2003
• Philadelphia, Pennsylvania
• Athula Alwis, ACAS, MAAA, American Re

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

• Surety Defined - One who at the request of
  another, and for the purpose of securing to him a
  benefit, becomes responsible for the performance
  by the latter of some act in favor of a third
  person, or hypothecates property as security
  therefor. One who undertakes to pay money or to
  do any other act in event that his principal
  fails therein. A person who is primarily liable
  for payment of debt or performance of obligation
  of another. One bound with his principal for the
  payment of a sum of money or for the performance
  of some duty or promise and who is entitled to be
  indemnified by some one who ought to have paid or
  performed if payment or performance be enforced
  against him. Term includes a guarantor. Black's
  Law dictionary 6th edition.

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SURETY DEFINED

• OBLIGEE

PRINCIPAL
SURETY
A joint undertaking with the Principal and the
Surety to fulfill a contractual obligation.
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A Paradigm ShiftBased on the paper Credit
Surety Pricing and the Effects of Financial
Market Convergence

• Current Status
• The 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 methods
• Regulators, rating agencies and investors have
  become more vocal about their concerns

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

• The spectrum of products is growing
• Contract surety
• Commercial surety
• Financial guaranty
• Credit insurance
• 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.

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

• 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.

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

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

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

• 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 markets
  revenues
• Insurers have since learned that credit is a
  catastrophe prone risk, and it must be managed
  accordingly
• Both insurers and insureds have learned that
  insurance is very different from finance, even if
  the risks look similar
• Regulators, rating agencies and investors have
  begun demanding greater transparency and better
  quantification control of credit risk exposures

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

• 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 cycle
• Does not adequately reflect changes in credit
  quality
• Does not adequately differentiate risks

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

• Financial Market Pricing Theory
• Surety EL ?(Financial Instrument EL, ?)
• ? Probability of Loss as a Surety Product /
  Probability of Default as a Financial Instrument
• Financial Instrument EL Notional Amount x
  Default Rate x (1 Recovery Rate) x Correlation
  Factor

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

• 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 (_at_ 5) 0.784
• (11) PV(Expected Loss) 537,695
• (9) x (10)
• Correlation Factor is 1.0 because this is
  a single principal

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

• 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 model
• Loss 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 into the picture using
  calibrated multi-variate normal copula approach.

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

• Risk Management Techniques
• Concentration limits
• Orderly exit strategy
• Collateral covenants
• Reinsurance
• Credit derivatives
• Diversification with non-credit

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

• Risk Management Requirements
• A sophisticated inventory system, tracking both
  assumed and ceded exposures, in a consistent
  manner, for all products investments
• A 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
  systems
• Understanding why the insured is buying protection

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

• 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.

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

• Question and Answer

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

• Contact Information
• Athula Alwis aalwis_at_amre.com