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The Actuary The magazine of the Institute & Faculty of Actuaries

ERM: Sovereign credit risk

For many years, a number of insurers head-quartered in developed economies have been pursuing growth opportunities in the emerging markets of Eastern Europe, Asia and beyond. In this article we consider certain risk and value issues that arise as a consequence of the generally lower government debt ratings associated with these emerging economies (see Table 1).

The domestic perspective: So what, if ’risk free’ is not really risk free?
Consider a domestic life insurer offering guaranteed benefits in an emerging economy such as Turkey or the Philippines. Its risk-minimal investment strategy is likely to involve a position in domestic government debt.

The fact that yields on such debt are higher than those of relatively stronger developed economies (Table 1), is not as a result of the generosity of these regimes! Rather, much of this differential can be attributed to higher inflationary expectations and, of particular relevance to this article, to a higher premium for the credit risk associated with these lower-rated bonds.

Table 1 (see below). Comparison of ratings and yields on domestic government debt issued by a selection of developed and emerging countries (31 December 2010)

A domestic insurer may well ignore the credit risk associated with debt issued by its government. As already mentioned, such debt may represent the least credit-risky practical investment option in the territory concerned. Furthermore, even in the event of defaulting on its debt, the government could take special measures to limit the losses suffered by policyholders. Arguably, the situation that would prevail post-default is so unpredictable that it cannot efficiently be risk-managed before the event. Certainly, the insurance regulator can hardly expect the insurer to doubt the performance of debt issued by the very same authority that established the regulator!

Where insurers ignore the default risk on domestic government debt, policyholders are likely to benefit in the form of cheaper products, as insurers will not need to charge for the credit risk underlying the government bonds backing their liabilities. Any domestic insurer that wished to offer its policyholders more security than offered by the domestic government debt, for example, by purchasing CDSs (credit default swaps) to protect such debt, would need to pass this cost on to its policyholders, resulting in considerably less-competitive products. In a competitive market, one wonders how many policyholders would be prepared to pay for this.

Foreign acquisition: To wrap or not to wrap?
Now enter a well capitalised internationally-active insurer. It decides to acquire the domestic insurer described above.

Can the acquiring company also ignore the possibility of a default of the domestic government debt backing the policyholder liabilities? The answer would appear to depend on the action the foreign insurer would take in the event of a domestic-debt default. Two very different courses of action are plausible: wrapping or not wrapping:

>> Wrapping – this course of action means that the foreign owner would stand by its local entity and prop it up in the event of a default of the domestic government debt. The foreign insurer is hence effectively credit wrapping the local government debt with its own resources. Such a course of action may be preferred by the foreign insurer in order to protect its global reputation and brand. By contrast, shareholders of purely domestic insurers may not face these same reputational pressures and may hence be more comfortable letting the insurer fail under such circumstances.

Of course, this credit wrapping has an economic cost. For the shareholders of a well capitalised insurer, this cost may equate to the market cost of CDSs on the domestic debt backing policyholder liabilities. This cost ought to be reflected in any acquisition price paid for the local insurer and in product pricing, even if the CDSs are not actually purchased. Otherwise, the shareholders may be better advised simply to attempt to write CDSs on the relevant debt and harvest the full risk premium, without all the hassles of the associated insurance business! In practice, the market in CDSs on domestic debt of developing countries is illiquid. Consequently the ’market’ price of such instruments will need to be estimated, taking account of pricing signals of related liquid instruments such as CDSs on any US-dollar denominated debt issued by these countries.

Needless to say, the acquirer will find it very difficult to charge for this wrap – which could amount to in excess of 100 bps pa for some countries – if none of its local competitors are doing so. At the very least, products that limit shareholder exposure to government credit risk should be considered, assuming that the target market would be attracted by such products.

>> Not wrapping – this is the situation where the acquiring insurer decides at outset that it would not prop up its local entity in the event of a domestic debt default. Such a course of action would permit the insurer to charge policyholder premiums that are in line with those of its domestic competitors and to be competitive in acquisition bids. Of course, the decision to walk away from an entity cannot be taken lightly by an international organisation with a reputation to protect, but it may well argue that domestic debt default amounts to something akin to ’political interference’. After all, the government concerned could have used other means to solve its funding problems, such as tax raising, spending cuts and money printing. The foreign insurer may well feel justified in refusing to finance another country’s budget deficit and may hence feel confident that, under such circumstances, it could emerge with its global reputation intact.

A word of caution though: the worst possible outcome for shareholders is for management to convince themselves at the outset that they will not support a local entity in the event of domestic government debt default, but when push comes to shove, they feel that they cannot walk away after all. For shareholders, this can probably be described as “neither having their cake nor eating it”!

The government-bond credit-risk blind spot
Even though the acquirer’s management may decide that it will not support the local subsidiary in the event of a domestic debt default, a credit wrap, albeit limited to the economic value of the entity, is still being given. Exhibit B illustrates the point very simplistically. There, the performance of a 100 currency unit (CU) shareholder investment in risky government bonds (i) via an investment company and (ii) as net assets within an insurance company, is compared, following a 5% partial bond default.

As would be expected, the post-default value of the shareholder investment via the investment company is CU 95, i.e. 95% of the pre-default value. But in the context of the insurance company, the post-default value of the net assets is only CU 45, the missing CU 50 having been “appropriated” to eliminate the value loss of that amount on the bonds backing the policyholder liabilities. To conserve shareholder value, this capped credit wrap needs to be recognised and priced at market-consistent rates.

Figure 1 (see below). Investment in risky government bonds – investment company versus insurer surplus


Bernhard Bergman is a member of the ERM PEC’s education, CPD, career support & development subcommittee. He has recently completed a six-year stint in the central risk management division of a large European reinsurer. All views expressed in this article are the author’s personal views.