1. Actuarieel Genootschap – AFIR Working Party Credit Risk 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

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

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

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

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

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

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

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

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

10. Actuarieel Genootschap – AFIR Working Party Credit Risk 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

11. Actuarieel Genootschap – AFIR Working Party Credit Risk 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,..)

12. Actuarieel Genootschap – AFIR Working Party Credit Risk 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

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

14. Actuarieel Genootschap – AFIR Working Party Credit Risk Comparison 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)

15. Actuarieel Genootschap – AFIR Working Party Credit Risk 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

16. Actuarieel Genootschap – AFIR Working Party Credit Risk 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)

17. Actuarieel Genootschap – AFIR Working Party Credit Risk 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 …)

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