Credit Risk and Solvency Capital Requirements

Credit risk permeates the assets of most insurance companies. This article develops a framework for computing credit capital requirements under the constant position paradigm and taking into account recovery rates. Although this framework was originally derived under the Solvency 2 regulation, it also provides concepts that can be useful under other international regula- tions. After a brief survey of the existing technology on rating transitions and default probabilities, the paper provides new results on risk premium adjust- ment factors. Then, three different procedures for reconstructing constant po- sition market-consistent histories of credit portfolios from quoted Merrill Lynch indices are given. The reconstructed historical credit values are modeled via mixed empirical-Generalized Pareto Distribution (GPD) dynamics and a de- tailed parameter estimation is performed. Several validations of the estimation are also provided. Finally, credit Solvency Capital Requirements are computed and an analysis of the results per rating class is given.