2019 April Q1 iii d

[Helloall]

Hi,

I was just wondering why does the required capital not change if the reinsurer credit rating stays the same:

Lets assume that the initial position of the company is:

Assets Liabilities
400 reinsurance 500
600 other assets

Lets assume that increasing the default probability for re insurer results in:

Assets Liabilities
100 reinsurance 500
600 other assets

If we assume that the SCR counterparty default stress for a company with a credit rating of BBB is a 10% increase to its default probability then wouldn't the SCR values be approximately:

SCR_initial = (unstressed A - unstressed L) - (stressed A - Stressed L) = (1000 - 500) - (960 - 500) = 40

SCR_end = (unstressed A - unstressed L) - (stressed A - Stressed L) = (700 - 500) - (690 - 500) = 10

I understand that if the credit rating drops then this could result in an increase in required capital as the stress could be a 50 increase in default probability.

 

[Lindsay Smitherman]

Hi - yes, we would agree that the Examiners' Report statement 'If the credit rating is not altered then the default risk module capital requirement would not change' is a little too strong. If you look at our ASET version of the solution for this question, you will see that we have softened the wording for this question part.

Having said that, although there would be some change in SCR, this is not likely to be material. That's why the solution focusses more on the situation where the credit rating has changed, and therefore a more onerous stress test would be applied.

In your figures above, in order to drop from 400 to 100 reinsurance recoveries asset value (if I have understood your figures correctly), you appear to have assumed a huge change in the default probability: eg from 0.1% to 75.1%, or 1% to 76% or whatever. This just isn't realistic, particularly given that we are considering a situation where the credit rating does not change. Most reinsurers are AA or A+ strength, so have expected default probabilities of perhaps 0.1%-0.3%. Even at the BBB rating the default probability might be only around 1%. Redoing the above figures with a more reasonable change in value (eg from 400 to 398, say) will give only a very small change in SCR.