Credit Risk Margin

Study guide: Exam 6C

The Credit Risk Margin is the MCT component covering the risk that a counterparty fails to pay: bond issuers, mortgage borrowers, derivative counterparties, agents and brokers holding premium, and — distinctively for an insurer — reinsurers. Factors are applied to exposures by counterparty type and credit quality.

• Reinsurance recoverables are a credit exposure, and often the largest single one. An insurer that has ceded heavily has replaced insurance risk with credit risk against its reinsurers, and the MCT charges for it — so the net capital benefit of reinsurance is the reduction in the insurance risk margin less the credit charge it creates.
• Registration and collateral change the charge. Cessions to unregistered reinsurers attract no capital credit at all unless collateralised; even for registered reinsurers, the recoverable carries a credit factor reflecting the reinsurer's rating.
• Bond credit risk is factor-based by rating and term. Government of Canada bonds attract essentially nothing; corporate bonds attract more as ratings fall, which — combined with the market risk margin — is why insurers' bond portfolios skew to high grade.
• Concentration matters beyond the formula. The factors are applied exposure by exposure, so an insurer with 80\% of its recoverables from one reinsurer gets the same total charge as one with the exposure spread across eight. The formula does not see the concentration; ORSA and Concentration Risk management must.
• Under IFRS 17, the accounting parallel is the non-performance risk allowance on the reinsurance asset — the same economic exposure, measured for a different purpose, and the two should be consistent in their view of counterparty quality.

Does the Reinsurance Actually Save Capital? An insurer cedes \$150 million of claim liabilities under a quota share. This reduces the insurance risk margin by \$27 million. The reinsurer is registered and A-rated, attracting a credit factor of 3\% on the recoverable. Ceded premium is \$42 million against expected recoveries with a present value of \$36 million.

Assess the capital and economic effect.

Answer Capital effect:

\begin{align*}
\text{Insurance risk reduction} &= -\$27\text{M} \\
\text{Credit risk added} &= +0.03(\$150\text{M}) = +\$4.5\text{M} \\[4pt]
\text{Net reduction in capital required} &= \$22.5\text{M}
\end{align*}

Effect on the buffer:

1.5 \times \$22.5\text{M} = \$33.75\text{M} \text{ of buffer released}

Economic cost of the reinsurance:

\$42\text{M} - \$36\text{M} = \$6\text{M}

Return on the capital released, ignoring the risk-reduction benefit itself:

\frac{\$6\text{M}}{\$33.75\text{M}} = 17.8\%

So the insurer is paying an effective 17.8\% for the released capital. Whether that is worth it depends entirely on the marginal value of capital to this insurer: if the MCT ratio is comfortably above the internal target, 17.8\% is expensive and the treaty is being bought for the wrong reason. If the ratio is near target and the alternative is a rights issue or curtailed growth, it is cheap.

What the calculation leaves out, and must be added to the decision: the reinsurance also removes tail risk, which is worth more than its expected-value cost — that is the whole point of buying it. The \$6 million is not purely a capital-efficiency payment; it is also the price of not bearing the extreme outcomes, and a comparison that ignores that will always make reinsurance look overpriced.