The need for insurers to improve the management of credit exposures has come into sharper focus recently. This has been under scrutiny from the FSA notably in their discussion paper in April 2003 “Review of UK insurers’ risk management practices” and the subsequent letter to the CEO to Life Insurers and Friendly Societies.
To recall some of the areas of weakness highlighted:
- Little to no separation of duties in determining the credit analysis and making investment decisions
- No independent review of in-house credit analyses outside the investment team
- No segregation of duties between policy implementation and compliance
- Management information could be improved generally
- No knowledge of total exposure to one counterparty/issuer
Source: FSA
Nowadays, policyholders’ funds permit increasing flexibility in the use of complex derivatives and hybrid securities. This encourages the need to improve the level of sophistication in the way in which credit exposures are measured and reviewed.
This is particularly important where the management of investment risk is undertaken by arm’s length asset management subsidiaries or indeed third party fund managers.
In general terms, the management of credit risk by insurers has not been approached in the same way as in the case of banks. The need for credit policies, committees and independent analysts has been open to debate for two reasons. First, the asset manager manages investment risk largely for the clients’ and not the insurers own account e.g. not risking its own capital. Secondly, the ability to measure and restrict credit exposure by, for example, using credit limits, is not a straightforward matter, as holdings of one line of stock will be spread over dozens, if not hundreds of funds.
The justification for a “streamlined” credit process is under review. The introduction of complex financial instruments causes audit committees and policyholders to question the efficiency of the underlying credit risk management process.
What are the implications?
The traditional investment manager’s approach to credit risk is changing as risk managers realise that there now has to be a more transparent demonstration of objective credit assessment and monitoring. For example, it is no longer sufficient to rely on the ratings assigned by the major agencies without some evidence of discretionary judgement about a potential counterparty by the fund manager.
This doesn’t mean that insurers today have to impose a cumbersome layer of bureaucracy in introducing new committees and policy documents. But it does mean that management have to show greater evidence that they are acting in the best interests of policyholders by saying “no” when the circumstances are right.
A good advocate can argue that the credit worthiness of an instrument is strong, by accentuating the positive and making less of the negative. There are a number of cases where supposedly highly rated credits have fallen from grace within a very short period of time, as a rumour has gathered pace into a more substantiated suspicion of irregularity.
The Way Forward
- How many executives board obtain accurate and timely information about their policyholders’ largest exposures?
- When the rumours start about a particular issuer, how quickly can you assimilate the information you require to gauge the aggregate exposure?
- Do you really have an accurate and comprehensive report that lists your exposure to one issuer for all types of instrument, including the at-risk component of a credit derivative?
If you don’t, it’s time to make a start. How do you go about it? Here a few suggestions
10 ways to improve your credit process
- Involve those who make the investment decision – avoid a “them and us” culture where the taking of decisions result in inflammatory arguments
- A pre-emptive approval process needs to be able to react quickly – investment decisions cannot wait until the next committee meeting a week later
- The evaluation of credit risk must include the efficacy and integrity of the legal documentation that underpins the instrument involved and the relationship with the counterparty
- Review limits regularly so that they are realistic and are not excessive in relation to the exposures concerned
- Keep in touch with your peer group to keep abreast of current practice in assessing counterparty risk limits
- Don’t get over-influenced by the strength of the commercial relationship with the counterparty
- Diversify the research you receive and don’t just rely on one supplier – opinions often differ
- Don’t just rely on the written page, speak to the analyst and ask the counterparty direct questions
- Implement an effective monitoring function but don’t crowd the business from being transacted
- Keep the bureaucracy down to a minimum
Contact Manuel Boger at enquiries@vedanvi.com to find out how Vedanvi can help insurers manage credit risk for commercial benefits.
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