Counterparty default risk (Solvency II)

In September 2008, the failure of Lehman Brothers reminds insurers that deposits and derivative contracts are not risk-free. The counterparty default module of the Solvency II standard formula, calibrated after that crisis, measures what the insurer would lose if those who owe it money did not pay. It splits in two. Type 1 covers exposures that are rated or can be, and poorly diversified: amounts recoverable from reinsurers, securitization and derivative contracts, deposits with ceding undertakings, bank accounts, guarantees received. For each, the calculation combines the loss given default, derived from the amount net of collateral, and the probability of default, which depends on the counterparty's credit quality step, and it accounts for concentration on one name. Type 2 covers diversified, unrated exposures: receivables from intermediaries and from policyholders, mortgage loans, with a flat treatment that distinguishes receivables more than three months overdue. The two combine with a correlation set at 75%. For an insurer that cedes a lot, it is a significant item, and the choice of reinsurers, ratings and collateral sets its level. Financial assets are not here: their defaults go through the spread module.