Compendium Of Credit Risk Resources - Casualty Actuarial Society

Compendium of credit risk resourcesJean-Philippe Boucher, Mathieu Boudreault and Jean-François Forest-DesaulniersMarch 13, 2017AbstractThis compendium summarizes the various aspects of credit risk that are important to insurancecompanies in general, namely corporate credit risk (single and multi-name), typical credit-sensitivesecurities, credit risk for individuals (including mortgage insurance), municipal credit risk, sovereigncredit risk, counterparty risk, and regulatory and enterprise risk management. The document alsoincludes considerations for property and casualty insurers and about their practices. Finally, we alsolist and link to important resources for practitioners and graduate students.Keywords Actuarial Applications & Methodologieso Capital management: Capital allocation, Capital requirementso Dynamic risk modeling: ALM, solvency analysiso Enterprise risk management: Analyzing/Quantifying risks, Financial Riskso Regulation and law: Rating agencies, Risk-based capital, SolvencyBusiness Areaso Credito SuretyFinancial and Statistical Methodso Asset and econometric modeling Asset classes (ABS, Corporate bonds, Equities, MBS, Municipal bonds) Credit spreadsPractice Areaso Consultingo Risk managementCasualty Actuarial Society E-Forum, Spring 20171

Compendium of Credit Risk ResourcesContentsFundamentals of Credit Risk . 51.1 Credit risk . 51.2 Legal aspects of credit risk . 51.3 Credit risk assessment . 61.3.1 Credit Rating Agencies. 61.3.2 Modeling, valuation and risk management . 71.4 References . 71.5 List of resources . 81.5.1 Books . 81.5.2 Websites and online reports . 91.5.3 Data.101.5.4 Computer programs .10Single-name corporate credit risk models . 112.1 Structural models . 112.1.1 Merton (1974) .112.1.2 First-passage models .122.1.3 Other structural models .132.1.4 Conclusion .132.2 Reduced-form models . 132.3 Hybrid models . 142.4 Loss given default . 142.5 References . 152.6 List of resources . 162.6.1 Books .162.6.2 Computer programs .17Portfolio corporate credit risk models . 193.1 Notions of dependence . 193.1.1 Sources of dependence .193.1.2 Dependence measures.193.1.3 Creating dependence.203.2 Professional models . 213.2.1 CreditMetrics .213.2.2 CreditRisk .223.3 Academic models . 223.4 References . 233.5 List of resources . 233.5.1 Books .233.5.2 Websites and online reports .243.5.3 Computer programs .25Credit risk for individuals . 264.1 Credit Scoring . 264.2 Basic Modeling and Actuarial Techniques. 274.2.1 Minimum Bias .274.2.2 Statistical Approaches .274.2.3 Number of defaults, N .27Casualty Actuarial Society E-Forum, Spring 20172

Compendium of Credit Risk Resources4.2.4 Loss given defaults, S .294.3 Typical Credit Risk Products Sold by Insurers. 304.4 References . 314.5 List of resources . 324.5.1 Books .324.5.2 Scientific Publications .334.5.3 Database .334.5.4 Computer programs .33Single-name credit-sensitive assets . 345.1 Securities . 345.1.1 Stocks .345.1.2 Corporate bonds.345.1.3 Credit default swaps .355.2 Credit risk assessment using security prices . 365.3 References . 375.4 List of resources . 375.4.1 Books .385.4.2 Computer programs .38Municipal securities. 406.1 Introduction . 406.2 Type and characteristics . 406.3 Ratings by recognized credit rating agencies . 406.4 Tax issues . 406.5 Insurance on municipal bonds . 416.6 Factors determining credit risk . 416.7 Credit risk model . 416.8 Liquidity risk . 426.9 List of resources . 426.9.1 Books .426.9.2 Data.426.9.3 Bibliography .43Portfolio credit risk derivatives and other structured assets . 447.1 Basket Credit Default Swaps . 447.2 Asset-Backed Securities . 447.2.1 Mortgage-Backed Securities.447.2.2 Collateralized Debt Obligations .457.3 References . 467.4 List of resources . 477.4.1 Books .477.4.2 Computer programs .47Counterparty risk . 498.1 Introduction . 498.2 Credit Risk . 498.3 Credit Default Swap (CDS) . 508.4 Reinsurer credit risk . 518.6 List of resources . 518.6.1 Books .51Sovereign credit risk . 539.1 Introduction . 53Casualty Actuarial Society E-Forum, Spring 20173

Compendium of Credit Risk Resources9.2 Sovereign credit risk factors . 539.3 Modeling and pricing. 549.4 Default history or sovereign insolvencies . 549.4.1 Russia (1998) .549.4.2 European crisis .549.5 List of resources . 559.5.1 Books .559.5.2 Website and online report .569.5.3 Database .569.6 Bibliography . 56Regulatory environment . 5810.1 Banks . 5810.1.1 Basel I, II, III .5810.1.2 Federal Reserve .5910.2 Insurance companies . 5910.2.1 NAIC – RBC.5910.2.2 Solvency I and II.6010.4 List of resources. 6010.4.1 Books .6010.4.2 Website and online reports .6110.5 Bibliography . 62Enterprise risk management . 6311.1 Reasons leading to ERM . 6311.2 Components of an effective ERM framework . 6411.3 Types of risks and mitigation . 6411.4 Modeling . 6511.5 Risk management process . 6511.6 References . 6511.7 List of resources. 6511.7.1 Books .6511.7.2 Websites and online reports .66General resources. 6712.1 Research papers . 6712.2 Data . 6812.3 Computer programs . 6812.4 Other resources . 68Casualty Actuarial Society E-Forum, Spring 20174

Compendium of Credit Risk ResourcesChapter 1Fundamentals of Credit Risk1.1 Credit riskAn organization (company, government, etc.) that has issued debt (or any other security) or has been extendedcredit and is unable to meet its obligations, partially or fully, is deemed to be insolvent. Thus, credit risk arisesfrom the potential loss a lender may suffer due to the borrower’s insolvency. Credit risk has two components:the uncertainty related to the timing of default (which may never occur) and the amount of loss at default (lossgiven default, which is the inverse of the recovery rate given default). A financial instrument (asset, derivative,etc.) with a price that depends directly or indirectly on the solvency of the underlying company is known as acredit-sensitive instrument (asset, security, etc.).There are several types of credit risk, depending on the type of issuer of credit-sensitive securities: Corporate credit risk, which involves private and public companies, primarily through corporate bondsbut also stocks, credit default swaps, etc. Consumer credit risk, which involves ordinary people through credit cards, lines of credit, loans,mortgages, etc. Sovereign, state/provincial/county, municipal credit risk, which arises primarily from bonds issued bycountries and their governments or their entities (such as utilities);Losses resulting from credit risk can be extremely large and can easily spread to impact the solvency of severalcompanies and even an entire economy. Life insurance companies and pension plans are heavily invested inlong-term bonds to match long-term cash flows and are thus particularly exposed to credit risk.There are many of examples of insolvency in the recent past. For example, Lehman Brothers went bankruptin September 2008, and General Motors filed for bankruptcy protection in June 2009 and reorganized thecompany thereafter. Russia defaulted on its debt in 1998, whereas Greece restructured its debt in 2012. Finally,the city of Detroit filed for bankruptcy in 2011.1.2 Legal aspects of credit riskIn the credit risk literature, various terms are often employed to define a similar event: insolvency, default,bankruptcy, credit event, etc. However, there are subtle differences among these terms, and thus, this sectionwill clarify some legal terms used to define credit risk.A default results from the failure of a debtor to make a payment on a debt, whereas insolvency is the legalterm equivalent to default. Bankruptcy is tied to an order from the court supervising an insolvent firm.Moreover, a credit event is a term often used when a credit derivative is established. Usually, the contract needsto specify all the events that trigger a payment. For participants belonging to the International Swaps andDerivatives Association (ISDA), credit events must be defined in the ISDA Master Agreement. Finally,technical default is a term used to designate a quasi-default or a default that has been avoided by governmentintervention, such as a distressed sale or exchange.When a company nears insolvency or has defaulted on a payment, the company may seek protection fromcreditors through the courts. In the US, the Bankruptcy Code (which is technically known as Title 11 of theCasualty Actuarial Society E-Forum, Spring 20175

Compendium of Credit Risk ResourcesUnited States Code) establishes the various types of bankruptcies: Chapter VII: bankruptcy for individuals and corporations, involving liquidation of assetsChapter IX: bankruptcy for citiesChapter XI: bankruptcy for individuals and corporations, involving restructuring of debtIn Canada, the Bankruptcy and Insolvency Act oversees the bankruptcy process for individuals and corporations.Corporate defaults thus generally fit into chapters VII and XI, but most corporations first seek torenegotiate the terms of their debt while protected by the courts (Chapter XI bankruptcy). That was the case forGeneral Motors in 2009, which reorganized its debt and eliminated several automotive brands. Lehman Brothersalso initially filed for Chapter XI bankruptcy before Barclays acquired the investment bank the following day.Few companies go directly to a Chapter VII bankruptcy, although that was indeed the case for consumerelectronics retailer Circuit City (acquired much later) and video game developer and publisher Acclaim. Manyfinancial institutions and investment banks technically defaulted in 2008 after requesting help from the USgovernment through the Troubled Asset Relief Program (TARP) to find a buyer for their toxic assets.There are various types of creditors in a company who are entitled to the cash flows of the debt when acompany goes into restructuring or liquidation. The most senior creditors are always repaid first when thecompany is insolvent, whereas junior creditors and stockholders usually receive what remains. This is known asthe seniority of a debt, whereas the latter money distribution mechanism is known as the absolute priority rule.For example, when a Canadian individual goes bankrupt, any amount owed to the Canada Revenue Agency (theCanadian equivalent of the IRS) has to be paid first, followed by mortgages, credit cards and other types ofloans. Senior debt is thus less risky and trades at a lower interest rate.When countries, states or cities default, they can restructure their debt with their creditors or seek help fromother countries. For example, in the period from 2010 to 2012, Greece received help from the InternationalMonetary Fund (IMF) and other European countries in exchange for implementing drastic austerity measures.Privatization of national services and utilities can also be used to quickly raise money in the event of default.1.3 Credit risk assessmentGiven the extent of the risk involved, it is very important for an investor to assess the credit risk on a security.However, making such an assessment is far from easy. Although it is possible for an investor to use models anddata to infer the quality of an asset, there are firms that specialize in evaluating the credit risk of any entity(corporation, municipality, country, etc.).1.3.1 Credit Rating AgenciesA credit rating agency is a private corporation with the core business of assessing the quality of a debt contract.Investors demand information on the quality of

Compendium of credit risk resources . Jean-Philippe Boucher, Mathieu Boudreault and Jean-François Forest-Desaulniers . March 13, 2017 . Abstract . This compendium summarizes the various aspects of credit risk insurance that are important to companies in general, namely corporate credit risk (single and multiname), typical credit-sensitive -