Use of dynamic financial modeling to estimate probabilities of likely credit losses.
Each simulation has 10,000 iterations
Default variables via Moody’s Investor Services (“Moody’s”)
Average recovery rates via Moody’s for All Bonds
Apply historical average credit default rates and recovery rates to individual securities to estimate annualized dollar credit exposure (i.e. contingent default analysis)
Apply a contingent claim approach to determine a range of adverse, annualized dollar-credit exposure and book income impact.
During the period, each security (CUSIP) has two possible outcomes based upon the average expected annual credit default rate by rating class.
Default event assumes loss of book value (i.e. accounting value) mitigated by potential recovery rates.
Default event assumes loss of book income for the period, which is then adjusted to represent lost yield or “credit risk-adjusted” book yield.
By fully understanding your insurer’s portfolio credit position, you will have a more accurate expectation of investment yield and total return.
Managing and monitoring credit risk starts with understanding that- The target spread you think you are achieving for interest sensitive products may not be achieved. Arbitrarily choosing a credit default factor in pricing liability products is fraught with danger.
– Investing for the ‘best yield’ is probably a delusion. The stated yield to maturity on a bond portfolio is probably NOT what you will ultimately receive.
– Credit risk must be actively managed for success. The longer an investment grade corporate bond is held, the higher the probability of default since the historical transition in credit ratings for such securities is downward.
– Your company’s actual default rate will probably be worse than the investment grade corporate bond universe. Using rating agency default factors alone for estimating credit risk severely understates true credit risk, depending upon the size and diversity of your portfolio. The following graphs are indicative of the difference in credit risk profile for the corporate bond universe and a well diversified insurer portfolio.