Credit Risk transfer OECD-IAIS-ASSAL Fourth Conference on Insurance Regulation and Supervision in Latin America Punta Cana, Dominican Republic, May 6 th -9 th, 2003 Jens Verner Andersen

2 Outline  Profile of credit risk transfer market  Incentives for undertaking risk transfers  Financial stability implications  Concluding remarks

3 Introduction  Credit risk transfer mechanisms comprise a wide group of credit derivatives  Transfer risks embedded in credit lending (corporate loans or bonds)  Change financial sector landscape: Bridging bank and insurance activities with capital markets

4 Introduction (con’d) - building blocks  Credit derivatives isolate an entity’s/pool of credit’s risks  risks include bankruptcy, failure to pay and restructuring of bonds or loans  Liquid standardised markets – governed by 1999 ISDA Credit Derivatives definitions Reference entity Protection BuyerProtection Seller Premium Contingent payment on default

5 Credit derivative Volumes – 1996 to 2004

6 Maturity Profile of Market at Trade Inception

7 The Product Universe

8 Who buys

9 Who sells

10 Net sale of credit protection

11 Factors generating growth - protection buyers  Capital optimisation:  Increased focus on capital charges as an integral part of credit lending  Risk/return  Improved risk management options:  Sector  Geographic  Retain commercial clients:  without having negative concentration impacts  Preserve relationship discount  Regulatory capital relief

12 Factors generating growth - protection sellers  Enhancing yields: Decline in interest rates across the board in combination with lower supply of sovereigns have increased end- investors’ demand for new instruments.  Return on Capital: Deploy capital more efficiently - obtain higher risk adjusted returns.  Excess capital in the insurance sector  Leverage expertise and brand in related businesses

13 Value added in insurance companies  Separating value creation into two entities:  Insuring risks: Issuing insurance contracts that more than cover the associated production costs, including capital cost.  Investing cash from premiums until claims are paid: Achieving an investment result that beats the benchmark on a risk-adjusted basis.  Insurance companies focus on shareholder value by:  Managing capital more efficiently: constrain capital to business generating sufficient profit.  Risk transfer techniques: Credit enhancement is innovative use of surplus capital.  Apply basic underwriting skills in related areas

14 Factors generating growth - market factors  New product types - Not only a hedging device  Structured products enhance liquidity in credit derivative markets  Broader investor interest  Continuous price setting in largest credit types in electronic systems (eg. Bloomberg)

15 Financial stability implications  Regulatory arbitrage  Regulatory  Capital  Accounting  Learning curve risks  Complex business on the borderline between banking and insurance: Do market participants understand risks?  Risk management  Adequate pricing and proper valuation are demanding but important when risks crystallise.  Counterpart exposures may still exist  An integral part of corporate culture

16  Transparency and disclosure  Lack of transparency  Rating agencies play a special role  Fitch Ratings special report: Global Credit Derivatives: Risk Management or Risk  Consumer protection issues  New types of risks have been transferred to small investors in CIS type schemes, variable annuities, and DC pension schemes  Pay more attention to aspects related to final consumers Financial stability implications (cont’d)

17 Concluding remarks  Potential benefits from credit derivatives:  Risk transfer markets offer opportunities for improved risk management.  Facilitate more manageable credit- and insurance cycles as deployment of capital is improved.  Depends on management of new risks  Capital market innovation is a challenge for users and authorities.  Capital market integrity issues related to accounting, capital and consumer protection  Enhanced transparency is needed