5.4.1 Calculation of the Credit risk charge

5.4. Credit risk

5.4.1 Calculation of the Credit risk charge

L1-130. The Credit risk charge is the determined by applying prescribed stress factors to specified net exposure amounts. Management actions are taken into consideration in the calculation of the Credit risk charge.
L1-131. The prescribed stress factors vary by exposure class, rating category and maturity. The classification of exposures between those categories, as well as the associated stress factors, are specified in the Level 2 text.

5.4.1.1 Exposure classes

L2-245. The Credit risk charge applies to all senior debt obligations of specified exposure classes of borrowers. Preferred shares and hybrid obligations, including subordinated debt, are excluded from the calculation of the Credit risk charge, and are instead subject to the Equity risk charge for hybrid debt/preference shares described in section 5.3.4.
L2-246. Credit exposures to national governments, multilateral development banks and supranational organisations are not subject to the Credit risk charge. Regional governments, municipal authorities, and other government entities whose debt is not issued or guaranteed by the national government are classified as public sector entities. Exposures to commercial undertakings owned but not guaranteed by governments or municipal authorities are classified in the corporates category.
L2-247. The corporates category includes exposures to banks and securities dealers, but excludes exposures to reinsurers. Rated commercial mortgages are included in the corporate exposure class.
L2-248. The infrastructure category includes debt exposures to infrastructure projects and corporates that meet definitions and criteria specified in sections 1 and 3 of Annex 3, provided that the exposure belongs to the corporates category specified in paragraph L2-247 prior to the application of the definition and criteria.
L2-249. The securitisation category includes all holdings of mortgage-backed securities and other asset-backed securities. It also includes any other assets where the cash flow from an underlying pool of exposures is used to service payments by a SPV to bondholders. If any of the assets in the pool of exposures underlying a securitisation exposure is itself a securitisation, then the exposure belongs to the re-securitisation category.
L2-250. The category short-term obligations of regulated banks includes demand deposits and other obligations that have an original maturity of less than three months, and that are drawn on a bank subject to the solvency requirements of the Basel Framework. All other bank exposures are included in the corporates category.
L2-251. Assets that are held for unit-linked business or in separate accounts and for which all credit risk on the assets fully flows through to policyholders are excluded from the Credit risk charge. However, the IAIG calculates a Credit risk charge for the increase in related liabilities (eg due to decreased future fee income) that would result from a credit risk loss on those assets, calculated as specified in this section.
L2-252. A non-paid-up financial instrument that qualifies for inclusion in capital resources is subject to the same credit risk charge as a direct credit exposure to the contingent capital provider.
L2-253. The Credit risk charge for off-balance sheet exposures is based on credit equivalent amounts calculated as specified in section 5.4.1.4.

5.4.1.2 Distribution of exposures by maturity

L2-254. For calculating the Credit risk charge, an effective maturity is calculated as follows for each credit exposure:

Effective Maturity

=\cfrac{\sum_t t\times CF_t}{\sum_t CF_t}

where $CF_t denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period$ t$.
L2-255. Where it is not possible to calculate the effective maturity of the contracted payments as noted above, a conservative measure is used, such as the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of the loan agreement.
L2-256. For OTC derivatives subject to a master netting agreement, the maturity is calculated as the weighted average of the maturities of the transactions subject to netting, with the weights proportional to the transactions’ notional amounts.
L2-257. All exposures to a group are aggregated and split by rating category before calculating the effective maturity.
L2-258. When an exposure is redistributed into another rating category due to the presence of an eligible guarantee or collateral, the effective maturity is calculated based on the term of the underlying exposure, not the term of the guarantee or collateral.

5.4.1.3 Reinsurance exposures

L2-259. Reinsurance exposures include all positive on-balance sheet reinsurance assets and receivables. Negative exposures are not included.
L2-260. Reinsurance exposures are considered net of cessions to mandatory insurance pools that are backed by either a governmental entity or jointly by the insurance market. Cessions to these mandatory pools are subject to a separate calculation.
L2-261. Reinsurance exposures include all credit recognised in the ICS risk charges due to the presence of reinsurance.
L2-262. In the case of catastrophe scenarios and life insurance stresses, the impact of the scenarios and stresses (before management actions) are calculated on a gross and net of reinsurance basis. The difference between the gross and net of reinsurance basis is then allocated to Credit risk categories based on the profile of the reinsurers that have provided cover. This calculation is made at the Catastrophe risk charge and Life insurance risk charge level (ie after diversification of the components of those risk charges).
L2-263. Modified coinsurance and funds withheld arrangements are subject to a risk charge even if there is no on-balance sheet reinsurance asset or the reinsurance asset is fully offset by payables.
L2-264. For funds withheld and similar arrangements, the IAIG may treat payables and other liabilities due to a reinsurer in the same manner as collateral provided that the arrangement meets all of the following conditions:
- a. The IAIG has executed a written, bilateral netting contract or agreement with the reinsurer from which the asset is due that creates a single legal obligation. As a result of such an agreement, the IAIG would have only one obligation for payment or one claim to receive funds based on the net sum of the liabilities and amounts due in the event the reinsurer failed to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances.
- b. The IAIG has a written and reasoned legal opinion that, in the event of any legal challenge, the relevant courts or administrative authorities would find the amount owed under the netting agreement to be the net amount under the laws of all relevant jurisdictions. In reaching this conclusion, the legal opinion must address the validity and enforceability of the entire netting agreement under its terms.
  - i. The laws of all relevant jurisdictions are:
    - • The law of the jurisdiction where the reinsurer is incorporated and, if the foreign branch of a reinsurer is involved, the laws of the jurisdiction in which the branch is located;
    - • The law governing the individual insurance transaction; and
    - • The law governing any contracts or agreements required to effect the netting arrangement.
  - ii. A legal opinion is recognised as such by the legal community in the IAIG’s home jurisdiction or by a memorandum of law that addresses all relevant issues in a reasoned manner.
- c. The IAIG has procedures in place to update legal opinions as necessary to ensure continuing enforceability of the netting arrangement in light of possible changes in relevant laws.

5.4.1.4 Off-balance sheet exposures

5.4.1.4.1 Credit equivalent amount for OTC derivatives

L2-265. The credit equivalent amount for OTC derivatives is calculated using the current exposure method from Annex 4, section VII of the Basel Framework . Under this method, the IAIG calculates the current replacement cost by summing:

a. The total replacement cost (obtained by marking to market) of all its contracts with positive value; and
b. An amount for potential future credit exposure calculated on the basis of the total notional principal amount of its book, split by residual maturity as specified in Table 21.

residual Maturity	Interest Rate	Excahge Rate and Gold	Equity	Precious Metals Except Gold	Other commodities
one year or less	0.0%	1.0%	6.0%	7.0%	10.0%
over one year to five years	0.5%	5.0%	8.0%	7.0%	12.0%
over five year	1.5%	7.5%	10.0%	8.0%	15.0%

〈 Table 21: Calculation of potential future credit exposure 〉

L2-266. Credit derivatives are not subject to the current exposure method.
- – Credit protection that is received is treated according to the provisions for guarantees and credit derivatives (cf section 5.4.2.2), while
- – credit protection that is sold is treated as an off-balance sheet direct credit substitute subject to a 100% credit conversion factor (cf section 5.4.1.4.2).
L2-267. For contracts with multiple exchanges of principal, the factors are multiplied by the number of remaining payments in the contract.
L2-268. For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset so that the market value of the contract is zero on these specified dates, the residual maturity is considered to be the time until the next reset date. In the case of interest rate contracts with remaining maturities of more than one year and that meet the above criteria, the add-on factor is subject to a floor of 0.5%.
L2-269. Contracts not covered by any category in Table 21 are treated as other commodities.
L2-270. No potential credit exposure is calculated for single currency floating/floating interest rate swaps; the credit exposure on these contracts is evaluated solely on the basis of their mark-to- market value.
L2-271. The add-ons are based on effective rather than stated notional amounts. Where the stated notional amount is leveraged or enhanced by the structure of the transaction, the IAIG uses the actual or effective notional amount when determining potential future exposure.
L2-272. Potential credit exposure is calculated for all OTC contracts (with the exception of single currency floating/floating interest rate swaps), regardless of whether the replacement cost is positive or negative.
L2-273. The IAIG may net contracts that are subject to novation or any other legally valid form of netting provided the following conditions are satisfied.
- a. The IAIG has executed a written, bilateral netting contract or agreement with each counterparty that creates a single legal obligation, covering all included bilateral transactions subject to netting. The result of such an arrangement is that the IAIG only has one obligation for payment or one claim to receive funds based on the net sum of the positive and negative mark-to-market values of all the transactions with that counterparty in the event that counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances.
- b. The IAIG has a written and reasoned legal opinion that, in the event of any legal challenge, the relevant courts or administrative authorities will find the exposure under the netting agreement to be the net amount under the laws of all relevant jurisdictions. In reaching this conclusion, the legal opinion addresses the validity and enforceability of the entire netting agreement under its terms.
  - i. The laws of all relevant jurisdictions are:
    - • The law of the jurisdiction where the counterparties are incorporated and, if the foreign branch of a counterparty is involved, the laws of the jurisdiction in which the branch is located;
    - • The law governing the individual insurance transactions; and
    - • The law governing any contracts or agreements required to effect the netting arrangement.
  - ii. A legal opinion is recognised as such by the legal community in the IAIG’s home jurisdiction or by a memorandum of law that addresses all relevant issues in a reasoned manner.
- c. The IAIG has internal procedures to verify that, prior to recognising a transaction as being subject to netting for capital purposes, the transaction is covered by a legal opinion that meets the above criteria.
- d. The IAIG has procedures in place to update legal opinions as necessary to ensure continuing enforceability of the netting arrangements in light of possible changes in relevant laws.
- e. The IAIG maintains all required documentation in its files.
L2-274. Any contract containing is not eligible to qualify for netting for the purpose of calculating the Credit risk charge.
L2-275. Credit exposure on bilaterally netted forwards, swaps, purchased options and similar derivatives transactions is calculated as the sum of the net mark-to-market replacement cost, if positive, plus an add-on based on the notional principal of the individual underlying contracts. However, for purposes of calculating potential future credit exposures of contracts subject to legally enforceable netting agreements in which notional principal is equivalent to cash flows, notional principal is defined as the net receipts falling due on each value date in each currency.
L2-276. The calculation of the gross add-ons is based on the legal cash flow obligations in all currencies. This is calculated by netting all receivable and payable amounts in the same currency for each value date. The netted cash flow obligations is converted to the reporting currency using the current forward rates for each value date. Once converted the amounts receivable for the value date are added together and the gross add-on is calculated by multiplying the receivable amount by the appropriate add-on factor.
L2-277. The future credit exposure for netted transactions is the sum of:
- a. 40% of the add-on as calculated in paragraph L2-276; and
- b. 60% of the add-on multiplied by the ratio of net current replacement cost to positive current replacement cost (NGR) where:

NGR

=\frac{\text{level if net replacement cost}}{\text{level of positive replace cost for transaction subject to legally enforceable netting arrangements}}

5.4.1.4.2 Credit equivalent amount for other off-balance sheet exposures

L2-278. Off-balance sheet exposures that are not arising from OTC derivatives are converted into credit exposure equivalents through the use of credit conversion factors (CCFs) applied to the item’s notional amount:
- a. Commitments with an original maturity up to one year and commitments with an original maturity over one year receive a CCF of 20% and 50%, respectively. However, any commitments that are unconditionally cancellable at any time by the IAIG without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness, receive a 0% CCF;
- b. Direct credit substitutes receive a CCF of 100%. If an IAIG has guaranteed, sold a credit derivative for, or otherwise assumed the credit risk of a debt security, the risk charge is the same as if the IAIG were directly holding the underlying security;
- c. Sale and repurchase agreements and asset sales with recourse, where the credit risk remains with the IAIG, receive a CCF of 100%;
- d. Forward asset purchases, forward deposits and partly-paid shares and securities, which represent commitments with certain drawdown, receive a CCF of 100%;
- e. Transaction-related contingent items receive a CCF of 50%;
- f. Note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) receive a CCF of 50%;
- g. Short-term self-liquidating trade letters of credit that an IAIG either issues or confirms arising from the movement of goods receive a 20% CCF;
- h. Where there is an undertaking to provide a commitment on an off-balance sheet item, the IAIG applies the lower of the two applicable CCFs;
- i. Off-balance sheet securitisation exposures receive a CCF of 100%.

5.4.1.5 Securities financing transactions

L2-279. The rating category for a securities financing transaction is the lower of that of the counterparty to the transaction, or that of the securities lent. Collateral received under securities financing transactions is recognised according to the same criteria as collateral received under regular lending transactions (cf section 5.4.2.1).

5.4.1.6 Credit risk stress factors

L2-280. The following tables contain the ICS Credit risk stress factors for the exposure classes by ICS RC and maturity:
L2-281. The Credit risk stress factor for policy loans is 0%. The stress factor for short-term obligations of regulated banks, as defined in paragraph L2-250, is 0.4%. The stress factor for receivables from agents and brokers is 6.3%. All other assets receive a stress factor of 8%. The IAIG may exclude outstanding premiums from the exposure if insurance liabilities are recorded for the contracts relating to the outstanding premiums and the outstanding premiums are unrecorded in line with the release of the insurance liabilities when the contracts expire upon the policyholder’s default.

5.4.1.7 Mortgage Loans

5.4.1.7.1 Commercial and agricultural mortgages where repayment depends on property income

L2-282. Depending on data availability, the risk charge is calculated using one of the three following methods, in decreasing order of preference:
- a. Method 1: risk charge based on the ICS Commercial Mortgage (CM) category as determined by loan-to-value (LTV) and debt service coverage ratio (DSCR);
- b. Method 2: risk charge based on the ICS CM category as determined by LTV only; or
- c. Method 3: no Credit Quality Differentiator used.
L2-283. For agricultural and commercial Method 1, the mapping of the ICS CM categories 1 to 5 to LTV and DSCR is provided in Table 27. Categories CM6 and CM7 are for delinquent loans and loans in foreclosure, respectively.
L2-284. For agricultural and commercial Method 1, the following stress factors are used:
L2-285. For agricultural and commercial Method 2, where only LTV data is available, the mapping of the ICS CM categories 1 to 4 to LTV and the associated stress factors are provided in Table 29. As for Method 1, categories CM6 and CM7 are for delinquent loans and loans in foreclosure, respectively.
L2-286. For agricultural and commercial Method 3, where LTV and DSCR data are not available, a flat 8% stress factor is used.

5.4.1.7.2 Commercial and agricultural mortgages where repayment does not depend on property income

L2-287. When the LTV ratio of the mortgage is above 60%, the risk factor is that of a regular credit exposure to the borrower. When the LTV ratio of the mortgage is 60% or lower, the risk factor is the lower of 3.6% or the risk factor for a regular credit exposure to the borrower.

5.4.1.7.3 Residential mortgages

L2-288. For performing28 residential mortgage loans for which repayment depends on income generated by the underlying property, the factors applied are based on the mortgage’s LTV ratio, as specified in the following table:
L2-289. For performing residential mortgage loans for which repayment does not depend on income generated by the underlying property, the factors applied are based on the mortgage’s LTV ratio, as specified in the following table:
L2-290. For non-performing mortgage loans, the factor applied is 35%.