5.4. Credit risk

5.4.2 Recognition of collateral, guarantees and credit derivatives

• L1-132. In determining the net exposure value, collateral and guarantees may be taken into consideration. The Level 2 text specifies the criteria for the recognition of collateral, guarantees and credit derivatives.

5.4.2.1 Recognition of collateral

• L2-291. A collateralised transaction is one in which:
  • a. An IAIG has a credit exposure or potential credit exposure; and
  • b. That credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.
• L2-292. Only the following collateral categories are eligible to be recognised:
  • a. Securities that are either issued by a sovereign entity or have ICS RC 4 or better;
  • b. Gold;
  • c. Mutual funds where:
    • • a price is publicly quoted daily; and
    • • the mutual fund is limited to investing in the eligible collateral listed above.
  • d. Letters of credit, and
  • e. Cash.
• L2-293. The Credit risk charge calculation takes into account collateral provided all of the following requirements are met:
  • a. The effects of collateral are not double counted. In particular, collateral on claims for which an issue-specific rating is used that already reflects that collateral is not recognised. All criteria around the use of ratings remain applicable to collateral.
  • b. All documentation used in collateralised transactions are binding on all parties and legally enforceable in all relevant jurisdictions. The IAIG has conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertaken such further review as necessary to ensure continuing enforceability.
  • c. The legal mechanism by which collateral is pledged or transferred ensures that the IAIG has the right to liquidate or take legal possession of the collateral in a timely manner in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Furthermore, the IAIG has taken all necessary steps to fulfil those requirements under the law applicable to the IAIG’s interest in the collateral for obtaining and maintaining an enforceable security interest, eg by registering it with a registrar, or for exercising a right to net or set off in relation to title transfer collateral.
  • d. The credit quality of the counterparty and the value of the collateral do not have a material positive correlation. For example, securities issued by the counterparty – or by any related group entity – are not eligible.
  • e. The IAIG has clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly.
  • f. Where collateral is held by a custodian, the IAIG takes reasonable steps to ensure that the custodian segregates the collateral from its own assets.
  • g. The collateral is pledged for at least the life of the exposure.
• L2-294. Where the collateral is denominated in a currency different from that in which the exposure is denominated, the amount of the exposure deemed to be protected is 80% of the amount of collateral, converted at current exchange rates.

5.4.2.1.1 Default approach to the recognition of collateral: the substitution approach

• L2-295. The portion of an exposure that is collateralised by eligible financial collateral valued at market is redistributed into the rating category applicable to the collateral instrument, while the remainder of the exposure is assigned the rating category appropriate to the counterparty.

5.4.2.1.2 Alternative approach for collateralised non-life reinsurance exposures: the haircut approach

• L2-296. Under the haircut approach, collateral may be recognised if it satisfies requirements a) to f) of paragraph L2-293 and is pledged for at least one year.
• L2-297. The haircut approach reduces the exposure amount to account for collateral held by the ceding insurer. The adjusted reinsurance exposure is defined by:

• L2-298. The risk charges for Non-life and Catastrophe risks are equal to the reduction in the ICS risk charges attributable to the reinsurance arrangement. This amount is aggregated with the Market risk charge and the Credit risk charges using 25% correlations.
• L2-299. The Credit and Market risk charges are specified as follows:
  • a. The Credit risk charge is calculated for all of the assets held as collateral.
  • b. The Asset Concentration risk charge is the granularity adjustment for all of the assets held as collateral, calculated on a standalone basis (ie in isolation from the ceding insurer’s own asset portfolio).
  • c. The Currency risk charge is calculated on a standalone basis for the reinsured liabilities in combination with the assets held as collateral. For the purpose of this calculation, the base currency is taken to be the currency in which the ceded liabilities are denominated, and the deduction referred to in point g of paragraph L2-230 is not applied.
  • d. The Interest Rate and Non-Default Spread risk charges are calculated on a standalone basis for the ceded liabilities in combination with the assets held as collateral.
  • e. The Equity and Real Estate risk charges are calculated for all of the assets held as collateral.
  • f. The Asset Concentration, Currency, Interest Rate, Non-Default Spread, Equity and Real Estate risk charges are aggregated to obtain the Market risk charge using the correlations specified in section 5.3.1.
• L2-300. The resulting Credit risk charge for collateralised non-life reinsurance is equal to the adjusted reinsurance exposure multiplied by the Credit risk factor applicable to the reinsurer.

5.4.2.2 Recognition of guarantees and credit derivatives

• L2-301. In order to determine the ICS RC of its counterparties, the IAIG may take into account the credit protection provided by guarantees and credit derivatives, provided that all of the following conditions are met:
  • a. The guarantees or credit derivatives are direct, explicit, irrevocable and unconditional.
  • b. The guarantor or protection provider belongs to a higher rating category than the counterparty covered by the guarantee or protection.
  • c. The IAIG fulfils certain minimum conditions relating to risk management described in section 5.4.2.2.1.
• L2-302. The capital treatment is founded on the substitution approach, whereby the protected portion of a counterparty exposure is assigned the rating category of the guarantor or protection provider, while the uncovered portion retains the rating category of the underlying counterparty.

5.4.2.2.1 Risk management requirements

• L2-303. The minimum conditions referred to in paragraph L2-301, applicable to both guarantees and credit derivatives, are the following:
  • a. The effects of credit protection are not double counted. In particular, no recognition is given to credit protection on claims for which an issue-specific rating is used that already reflects that protection. All criteria around the use of ratings remain applicable to guarantees and credit derivatives.
  • b. With the exception of credit protection provided by sovereigns as specified in paragraph L2- 317, a guarantee, counter-guarantee or credit derivative must represent a direct claim on the protection provider and must explicitly refer to a specific exposure or pool of exposures, so that the extent of the cover is clearly defined and incontrovertible.
  • c. The credit protection contract is irrevocable, except in case of non-payment by the protection purchaser of money due in respect of the credit protection contract.
  • d. There is no clause in the contract that allows the protection provider to unilaterally cancel the credit cover or to increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure.
  • e. The contract is unconditional, ie there is no clause in the protection contract outside the direct control of the IAIG that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due.
  • f. All documentation used for documenting guarantees and credit derivatives are binding on all parties and legally enforceable in all relevant jurisdictions. The IAIG has conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.
• L2-304. In addition to the requirements set in paragraph L2-303, the recognition of a guarantee is subject to all of the following conditions:
  • a. On the qualifying default/non-payment of the counterparty, the IAIG pursues the guarantor in a timely manner for any monies outstanding under the documentation governing the transaction. The guarantor makes one lump sum payment of all monies under such documentation to the IAIG, or the guarantor assumes the future payment obligations of the counterparty covered by the guarantee. The IAIG has the right to receive any such payments from the guarantor without first having to take legal action in order to pursue the counterparty for payment.
  • b. The guarantee is an explicitly documented obligation assumed by the guarantor.
  • c. Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee excludes certain types of payment, the corresponding amounts are treated as unsecured amounts.
• L2-305. In addition to the requirements set in paragraph L2-303, the recognition of a credit derivative contract is subject to all of the following conditions:
  • a. The credit events specified by the contracting parties cover at a minimum:
    • i. The failure to pay the amounts due under the terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is in line with the grace period in the underlying obligation);
    • ii. The bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and
    • iii. The restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (ie charge-off, specific provision or other similar debit to the profit and loss account).
  • b. If the credit derivative covers obligations that do not include the underlying obligation, point
    • g) below governs whether the asset mismatch is permissible.
  • c. The credit derivative does not terminate prior to the expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay.
  • d. Credit derivatives allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There is a clearly specified period for obtaining post-credit event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, point g) below governs whether the asset mismatch is permissible.
  • e. If the protection purchaser’s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation provide that any required consent to such transfer be not unreasonably withheld.
  • f. The identity of the parties responsible for determining whether a credit event has occurred is clearly defined. This determination is not the sole responsibility of the protection seller. The protection buyer has the right/ability to inform the protection provider of the occurrence of a credit event.
  • g. A mismatch between the underlying obligation and the reference obligation under the credit derivative (ie the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if:
    • i. The reference obligation ranks pari passu with or is junior to the underlying obligation; and
    • ii. The underlying obligation and reference obligation share the same obligor (ie the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.
  • h. A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if:
    • i. The latter obligation ranks pari passu with or is junior to the underlying obligation; and
    • ii. The underlying obligation and reference obligation share the same obligor (ie the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place.
  • i. Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees are eligible for recognition. Where an IAIG buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by increasing provisions), the credit protection is not recognised.
• L2-306. When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements above are met, partial recognition of the credit derivative is allowed, up to a maximum of 60% of the lower of:
  • a. The amount of the credit derivative; and
  • b. The amount of the underlying obligation.

5.4.2.2.2 Eligible guarantors

• L2-307. Only the credit protection provided by the following counterparties are eligible for recognition:
  • a. Sovereigns;
  • b. Externally rated public sector entities, banks and securities firms with a higher rating category than that of the counterparty; and
  • c. Other entities, including parent, subsidiaries and affiliate companies of an obligor, provided they have a higher rating category than that of the obligor.
  • In addition, a guarantee or credit protection provided by a related party (parent, subsidiary or affiliate) of the IAIG is not eligible for recognition.

5.4.2.2.3 Capital treatment

• L2-308. The protected portion of a counterparty exposure is assigned the rating category of the protection provider. The uncovered portion of the exposure is assigned the rating category of the underlying counterparty.
• L2-309. Where the amount guaranteed or covered with credit protection is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority (ie the IAIG and the guarantor share losses on a pro-rata basis), the protected portion of the exposure receives the treatment applicable to eligible guarantees and credit derivatives, and the remainder is treated as unsecured.
• L2-310. Where an IAIG transfers a portion of the risk of an exposure in one or more tranches to protection sellers and retains some level of risk, and the risk transferred and the risk retained are of different seniority, all tranches are considered as securitisation exposures based on the ratings of the guarantors. If a tranche does not carry a rating, it is considered as an unrated securitisation exposure even if the underlying exposure is rated. Where such treatment leads to a Credit risk charge higher that the risk charge calculated without taking the guarantee into account, the IAIG may ignore the guarantee.
• L2-311. Materiality thresholds on amounts due below which no payment is made in the event of loss are considered unrated securitisation exposures.

5.4.2.2.4 Currency mismatches

• L2-312. Where the credit protection is denominated in a currency different from that in which the exposure is denominated, the amount of the exposure deemed to be protected is 80% of the nominal amount of the credit protection, converted at current exchange rates.

5.4.2.2.5 Maturity mismatches

• L2-313. When the residual maturity of the credit protection is less than that of the underlying exposure (maturity mismatch) and the credit protection has either an original maturity of less than one year or a residual maturity of less than three months, the protection is not recognised.
• L2-314. In other cases of maturity mismatch, the following adjustment is applied:

• L2-315. The residual maturity of the underlying exposure is taken as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period.
• L2-316. For the credit protection, embedded options that may reduce the term of the protection are taken into account so that the shortest possible effective maturity is used. In particular:
  • a. Where a call is at the discretion of the protection seller, the residual maturity corresponds to the remaining time to the first call date.
  • b. Where a call is at the discretion of the IAIG buying protection but the terms of the arrangement at origination contain a positive incentive for the IAIG to call the transaction before contractual maturity, the residual maturity corresponds to the remaining time to the first call date.

5.4.2.2.6 Sovereign counter-guarantees

• L2-317. Claims covered by a guarantee that is indirectly counter-guaranteed by a sovereign may be treated as covered by a sovereign guarantee provided that:
  • a. The sovereign counter-guarantee covers all credit risk elements of the claim;
  • b. Both the original guarantee and the counter-guarantee meet all the operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original claim; and
  • c. The cover is robust, and there is no historical evidence suggesting that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee.

5.4.2.2.7 Other items

• L2-318. Where an IAIG has multiple types of risk mitigation arrangements covering a single exposure, this exposure is subdivided into portions covered by each type of risk mitigation arrangement and the rating category for each portion is determined separately.
• L2-319. When a credit protection provided by a single protection provider has different maturities, it is subdivided into separate protections.