UK: The Credit Risk Transfer Market

A greater focus on risk management and a more disciplined approach to risk and return on a portfolio basis by large international banks, has led them to be net buyers of credit risk protection. In their quest to lessen the volatility of their earnings banks have become more active in originating and distributing loans rather than holding loans to maturity.

The insurance industry has become a net seller of credit risk protection, participating in this market from both sides of their balance sheet:

• As an investor in corporate credit risk to obtain higher yields and increased diversity in fixed income portfolios. Moving along the risk spectrum with increased holdings of assetbacked securities, collateralised debt obligations and in some cases alternative investments (e.g. hedge fund of funds).

• As an underwriter of credit risk to generate new premium income and create greater diversification of the overall risk portfolio. Corporate credit risk is viewed to be uncorrelated to traditional insurance underwriting risks and during the soft markets of the late 90’s some insurers were tempted to follow the monolines into the credit enhancement arena by writing financial guarantees, financial reinsurance and credit default derivatives.

For several high profile names this diversification in underwriting strategy proved to be a damaging business decision incurring material losses and a serious adverse impact on capital, ratings profile and management time. Most have now retrenched or exited the market. But what can we learn from their experiences?

• Banks assess credit risk using private and public data, usually obtained from a long banking relationship. The insurance companies who end up holding the credit risk usually have less information about the borrower than the original lender. If they have been overly optimistic in their modelling/ assessment of default probabilities/behaviour of assets, the projected loss ratios will be understated, premiums charged too low and capital reserves inadequate. _ Insufficient consideration was given to the need for adequate diversification of risk, with concentration seen in certain industry sectors (e.g. technology & telecoms).

• There was an over reliance upon the opinions of the rating agencies. Whilst it is important to understand the basis of the ratings opinion and the dynamics of the models used to estimate default probability. Ultimately the ratings opinion is a source of research to help inform the underwriter’s own prudent risk judgement.

The disclosure of CRT activities in the financial reports of insurers is patchy at best, and usually relegated to the footnotes. Rarely is there any comment on how CRT activities affect the overall risk profile and this lack of transparency makes it difficult for investors, analysts and lenders to make informed decisions on the financial stability of the insurer.

The CRT market is still relatively immature, though it appears most of the naive capital has left the market. I believe it is critical for those that remain to fully understand the basis of the original lender’s credit decision, the composition and likely performance of the loan(s) to enable the corporate credit risk to be priced adequately, including:

• Probability of default and how this may vary over the life of the asset;

• Expected recovery rates following default, and who is best placed to maximise recovery;

• Correlation of defaults within the portfolio;

• Concentration of exposure by counterparty, industry and geography.

Banks are prone to systemic risk and the evolution of the CRT market is undoubtedly a positive development for the financial markets. The insurance sector has an important role to play in the evolution of the CRT market, though they do need to maintain underwriting discipline. 

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