Dec 12

Credit Risk: Prepare Now For What Will Come Next

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While the press concentrates on the ‘sub prime crisis’, because it is so easy to put a face on it, insurers should be focusing heavily on good old fashioned credit risk.

Yes, default rates have hit 25 year lows at 0.74% of high yield bonds per S&P, but that measure is backward looking.

A more concurrent indicator would be the number of US corporate bond issuers being downgraded versus those being upgraded.  According to Moody’s, this ratio is now at 4.5 downgrades to upgrades, more than double the rate for October and the highest since the bad old credit days of late 2002.  As we all know, market signals are also flashing red, as there are amazingly over 150 issues trading at 1000 bps over US Treasuries.

And now, Moody’s late on Friday, placed the Aaa ratings of FGIC and XL Capital Assurance ynder review for possible downgrade. It affirmed the Aaa insurance ratings of MBIA CIFG, though it said the outlooks were “negative.”  A downgrade for any of these bond insurers would have negative impacts for insured bonds, especially those supposedly ‘safe’ municipal bonds.

‘What’s the next shoe to fall in the credit risk arena?’ may not be the correct question.  Perhaps ‘What and how many shoes?’ is a better question.

Although life insurers do allocate surplus in the form of asset valuation reserves for credit risk, PC insurers do not have such a valuation reserve.  We highly recommend that all insurers review the potential for credit losses and Other Than Temporary Impairment write downs over the next year (both expected values and probabilistic distribution of those values) in order to get a better idea of future portfolio performance.

There are many different ways to perform such an analysis.  However, using credit rating transition matrices, long term credit default performance as well as stress testing that performance is a good start.  It is much better to be prepared now than be surprised later.