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An Introduction to Credit Risk with a Link to Insurance. R.J.A. Laeven, University of Amsterdam and Mercer Oliver Wyman R.J. de Barbanson, Zanders & Partners AFIR Colloquium 2003 Maastricht September 18, 2003. Outline. Motivation Empirical relation between credit spreads and interest rates

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An Introduction to Credit Risk with a Link to Insurance


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    1. An Introduction to Credit Riskwith a Link to Insurance R.J.A. Laeven, University of Amsterdam and Mercer Oliver Wyman R.J. de Barbanson, Zanders & Partners AFIR Colloquium 2003 Maastricht September 18, 2003 Actuarieel Genootschap – AFIR Working Party Credit Risk

    2. Outline • Motivation • Empirical relation between credit spreads and interest rates • Credit risk models • Accounting and regulation Actuarieel Genootschap – AFIR Working Party Credit Risk

    3. Motivation I • Increase in credit risk on the Euro financial markets due to: • Introduction of the Euro • Stability and Growth Pact Actuarieel Genootschap – AFIR Working Party Credit Risk

    4. Motivation II Actuarieel Genootschap – AFIR Working Party Credit Risk

    5. Credit Spreads vs Interest Rates I • Decomposition of the yield-to-maturity on a credit risky asset: Actuarieel Genootschap – AFIR Working Party Credit Risk

    6. Credit Spreads vs Interest Rates II • Database of Eurobonds (January 1999 until December 2001) Actuarieel Genootschap – AFIR Working Party Credit Risk

    7. Credit Spreads vs Interest Rates III • Model specification: • Empirical results: Actuarieel Genootschap – AFIR Working Party Credit Risk

    8. Consequences for ALM • Inferior hedging quality of credit risky assets • Risk assessment of the debt portfolio is indispensable Actuarieel Genootschap – AFIR Working Party Credit Risk

    9. Measurement of Credit Risk • Influence of both bond portfolio selecting (return) and sensitivity (risk) increase • 3 models: • CreditMetrics (JP Morgan) • KMV (Moody’s KMV) • CreditRisk+ (CSFB) Actuarieel Genootschap – AFIR Working Party Credit Risk

    10. Definition Credit Risk • Expected Loss = 1) Default Probability x Amount Outstanding x 1 - Recovery Rate 2) Cost of Doing Business • Unexpected Loss = Deviation of Expected Loss Actuarieel Genootschap – AFIR Working Party Credit Risk

    11. CreditMetrics • CM estimates value of bond at end of credit-risk horizon (e.g. 1 year) by combining transition (“migrate from one rating class to another?”) and possible forward curves (AAA, AA, ..) Actuarieel Genootschap – AFIR Working Party Credit Risk

    12. KMV Model • “Equity is call-option on asset value” • Default probability is estimated on market information (stock price and volatility interest rate structure), financial statements, and (subjective) risk perceptions • Default probability is used to calculate (un) expected loss Actuarieel Genootschap – AFIR Working Party Credit Risk

    13. CreditRisk+ • CR+ assumes two states 1) Default, and 2) Non-default • Default frequency ~ Poisson • Recovery rate changes through time  Losses follow a density distribution Actuarieel Genootschap – AFIR Working Party Credit Risk

    14. Similarities EL= Default prob. x Exposure x (1 -recovery rate) EL and UL is output Differences Rating (CM/CR+) vs. Stock price (KMV) Spread risk (CM) vs. default risk CR+/KMV) Market model (CM) vs. Default model (CR+/KMV) Comparison Actuarieel Genootschap – AFIR Working Party Credit Risk

    15. Remarks • CR+ model for hold-to-maturity portfolio • CM model for available-for-sale portfolio • KMV is an arbitrage model, that can be used to compare implied price and market price of credit risk Actuarieel Genootschap – AFIR Working Party Credit Risk

    16. Credit Risk and Regulation • EU solvency system is now based on 3 pillars: 1) assets, 2) technical provision, and 3) required solvency margin • Solvency II in progress: • 1) Estimation of total risk (among other risk due credit, underwriting, market, etc.), and 2) Impact on Risk Based Capital • White paper Solvency Test PVK (FTK) Actuarieel Genootschap – AFIR Working Party Credit Risk

    17. Credit Risk and Accounting • Implementation of IAS/IFRS Rules • IAS39 distinguishes between the valuation methodology of asset portfolios • Portfolios qualified as hold-to-maturity should be valued at amortized costs (CreditRisk+ …) • Portfolios qualified as available-for-sale should be valued at fair value (CreditMetrics …) Actuarieel Genootschap – AFIR Working Party Credit Risk

    18. Questions? Actuarieel Genootschap – AFIR Working Party Credit Risk