Credit Risk Modeling in ING

Investment Actuary Symposium/AFIR Colloquium

November 10, 2004 Frederik J. ten Lohuis, Head of Credit Risk Management, ING Insurance Americas

1: INTRODUCTION: Why credit risk modeling?

2: CREDIT RISK MEASUREMENT CONCEPTS

AGENDA
3: APPLICATIONS FOR CREDIT RISK MEASUREMENT TECHNIQUES

SECTION

INTRODUCTION: Challenges and Opportunities

The Credit Risk Challenge

Credit quality is very dynamic

over the business cycle as individual credit quality changes

Exposures need constant monitoring Credit portfolios must be actively managed Active portfolio management requires accurate measurement of
portfolio risk and return

ING has implemented an Economic Capital framework to create an

appropriate set of incentives for its business units

Key Questions for a Life Insurance company

What is the risk and return of the investment portfolio? Which are the most/least attractive exposures from a risk/return perspective? What is the range and likelihood of future portfolio values? Given this range and likelihood, how much equity or capital is required? Is the return on capital appropriate? What are the major sources of concentration and diversification? How can portfolio performance be improved?
Without the use of credit risk measurement techniques, these questions cannot be answered

The Opportunity

Active credit risk portfolio management can lead to substantial improvement in return per amount of risk & more efficient use of economic capital.

Elements of Portfolio Credit Risk

Portfolio Credit Risk is the risk of changes in the market value of a portfolio over a time horizon as a result of changes in credit quality.

Portfolio Credit Risk

Exposure Credit Risk Recovery Rates (or LGD)

Correlation in Exposure Values Asset Correlation

Concentration (Amount Held)

Default Probabilities

SECTION

CREDIT RISK MEASUREMENT CONCEPTS

What is Risk?
Risk is defined as volatility in earnings
RISK P&C Risk
CREDIT RISK MARKET RISK OPERATIONAL RISK MORTALITY RISK MORBIDITY RISK BUSINESS RISK

Earnings Volatility due to variation in credit losses

Earnings Volatility due to changes in market prices or liquidity

Earnings Volatility due to one-off losses (fraud, systems failure, litigation)

Earnings Volatility due to variation in death rates

Earnings Volatility due to changes in longevity

Earnings Volatility due to changes in operating economics (volume, margins, costs)

For Emerging Market exposures ING splits Credit Risk in Credit Risk and Transfer Risk

Credit Risk is best described by 2 measures

Average anticipated loss within a risk category through time. Unexpected Loss: Variance of actual loss over time (1 standard deviation).
EXPECTED LOSS
Anticipated avg. annual loss rate Foreseeable cost of doing business Not risk as investors think of it, but rather a charge which affects anticipated yield
Loss Rate

Expected Loss:

UNEXPECTED LOSS
Results in volatility of return over time

EL

Unanticipatable though inevitable

UL
Time

Requires a balance sheet cushion of economic capital

Differentiated Cost of Risk

Differentiated Capital

EL and UL are important inputs for a RAROC Calculation

RAROC: A measure of profit per unit of risk adjusted capital

Loss Rate

RAROC CALCULATION -/-/Revenue Expense Expected Loss

EL UL
Time

=
/

Risk Adjusted Return

Economic Capital

RAROC

Expected Loss
Borrower related
EXPECTED DEFAULT FREQUENCY 0.10% (A-)

Facility Related
EXPOSURE AT DEFAULT $100 mm LOSS GIVEN DEFAULT 60%

EXPECTED LOSS $60,000

Expected (Credit) Loss has 3 components which should be derived bottom-up from the risk characteristics of individual transactions Expected Default Frequency is the probability that the borrower will default
- Derived from the companies borrower risk rating - Depends on the term of the facility

Loss Given Default is the percentage of Exposure at Default that is expected to be lost in case of a default by the borrower
- Depends on the seniority, and the type, quantity and quality of the cover

Expected Default Frequency

Risk ratings are mapped to (1-year) default probabilities

Internal Rating 1 2 3 4 5 6 7

S&P Eq. AAA ABBB BB+ BBB+ B

1 year PD (bp) edf 2 10 35 80 160 350 750 1

rating

6
-> risk

Loss Given Default can be broken down into 3 Components

PRINCIPAL LOSS

COST OF CARRY

ADMINISTRATIVE COST

LOSS GIVEN DEFAULT 60%

Collateral Type Collateral Quality Collateral Amount Tier Position 50%

Workout Time Funding Assumption 7%

Workout Process Cost Structure 3%

Of the 3 components, Principal Loss is by far the most important one

Portfolio Loss Distribution

2.00% 1.80%

Actual Portfolio Loss

1.60% 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00%

Rarely, the portfolio has very large losses

Most of the time, the portfolio has smaller than the Expected Loss Sometimes, the portfolio has losses equivalent to the Expected Loss

Probability

Year

$0

EL

Loss

Credit Risk Portfolio Modeling

A Credit Risk Portfolio Model is used: a) to determine the shape of the loss distribution;
Probability

b) to determine the amount of credit risk capital needed;

and

c) to allocate credit risk capital to individual assets

$0

Loss

Building Blocks of the Economic Capital (EC) calculation

Facility UL

Portfolio UL

Facility ULC

Portfolio EC

Facility EC

Default Correlations

UL = Unexpected Loss ULC = Unexpected Loss Contribution EC = Economic Capital

Unexpected Loss is defined as the standard deviation of actual loss and depends on the same variables as Expected Loss At transaction level it is calculated as follows:
UL = EAD EDF LGD LGD 2 0.25 + LGD 2 * ( EDF EDF 2 )
$2,049,302 = $100 mm * SQRT { 0.10% * (60% - 36%) * 0.25 + 36% * (0.10% - 0.0001%) }

Economic Capital: Capital required to sustain potential losses

Confidence level depends on the desired debt rating
frequency of occurrence

AA-rating

EL

=> 0.05% default probability => 99.95% confidence level => capital multiple 7

UL Economic Capital = 7 * UL 0.05%

loss rate

Economic Capital: a simplified calculation method

For internal performance measurement and pricing ING uses a simplified calculation method: Economic Capital
$2,151,767

=
=

Unexpected Loss
$2,049,302

x
*

Correlation x Factor
0.15% *

Capital Multiple
7

PD Exposure Loss Given Default

InterPortfolio Correlation

Desired Debt Rating (AA)

whereby correlation factor is based on insights gained from credit risk portfolio modeling using regression analysis; correlation factor is a function of rating, LGD, R-squared, term, industry, country

SECTION

APPLICATIONS FOR CREDIT RISK MEASUREMENT TECHNIQUES

Consistent bottom-up credit risk measurement is the foundation for a series of value added initiatives

Risk Adjusted Pricing Risk-Adjusted Capitalisation

BOTTOM-UP BOTTOM-UP CREDIT RISK CREDIT RISK MEASUREMENT Credit Risk MEASUREMENT

Risk-Adjusted Profitability Measurement

Management Reporting Provisioning Policy

Credit Risk Portfolio Management

The goal of managing credit risk concentrations is not to reduce loan losses, but to reduce their volatility
Studying default correlations is of great importance!

frequency of occurence

loss rate

Summary
Credit Risk Models are used by ING to build a better understanding of the volatility of credit losses Within ING Credit Risk Modeling is an important building block of the internal Economic Capital framework ING believes that Credit Risk Modeling will allow us in the coming years to increase the risk adjusted performance on our investment portfolios
But also

ING understands that models are as good as the assumptions that need to be made to run the models ING is aware that credit risk models will complement but never replace common sense in managing a business

Credit Risk Modeling In AIG

Paul Narayanan
Investment Actuary Symposium/AFIR Colloquium November 10, 2004

Credit Risk Management

Disclaimer & Scope

We will only talk about models for measuring risk/loss, not pricing models used in credit derivatives. Views expressed here are of the presenter alone, based on work at AIG and elsewhere. They should not be construed to reflect the views of American International Group. We will focus on two components of credit risk : Default Probability and Loss Given Default

Some Sources of Credit Exposure

Investment Portfolios (some examples)
Non-Structured Assets: bonds, private placements Structured Assets: CDOs, CMBS, ABS Derivatives

Insurance Portfolios (some examples)

Risk Retention by Insureds through Captives Deductibles Funding Reinsurance Recoverables Counterparty Risk in Life Settlements Credit Insurance

Three faces of Credit Risk

Using Basel terminology, credit risk is the combined effect of :
Exposure, which may be easy or difficult to measure Likelihood of default (or quality migration) Loss Given Default (or quality migration)
Expected Loss = EAD * PD * LGD Unexpected Loss = Loss at a preset confidence level Expected Loss is included in loan/bond pricing Unexpected Loss defines the capital to be held

Three Classes of Credit Models

Credit administration policies, reviews
Default models Loss models Credit equivalence models

Investment & portfolio management

Value at Risk & Stress Testing Portfolio concentration Asset allocation

Structured finance
Tranche risk analysis Analyzing deep out of the money puts

Default Risk Models

Default Risk Models Specific Uses

Credit Authority Deriving a Rating System Setting Credit Limits Allocating economic capital Early Warning / Monitoring Reserving Regulatory Capital most failures are due to credit losses Securitization

Default Risk Models

Used to provide a common credit language for talking about credit risk Involve Quantitative/qualitative analyses, score cards Structured and preferably objective to allow comparability In the end, all analysis boils down to a rating or a score as a measure of nonpayment risk, which in turn is used in articulating credit policy (e.g. house limits)

Default Risk Models Used in Credit Management

Model: a risk measurement structure/framework that exists and is continually updated
Rating agencies Moodys, S&P, Fitch... Obligor Risk Ratings for rated and unrated companies Financial Ratio Based Models Expert systems and Score cards Equity value & Volatility-based models KMV EDF Shadow ratings an automated way to replicate ratings: ratio based, artificial neural networks

Financial Ratio Based Models

Use financial ratios in multivariate context to predict bankruptcy/ratings/bond defaults Failing firms exhibit distinct financial characteristics relative to healthy firms

Ratio Comparison Zeta Model

(Source: Caouette, Altman & Narayanan, Managing Credit Risk, 1999)

Ratio

Bankrupt NonBankrupt Re t u r n o n Asse t s -0.0055 0.1117 Ea r n in g s St a b ilit y 1.6870 5.7840 Debt Service 0.9625 1.1620 Cumulative Profitability -0.0006 0.2935 Liquidity 1.5757 2.6040 Capitalization 0.4063 0.6210 Size 1.9854 2.2220

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Ratio Comparison S&P Ratings

(Source: De Servigny, A., et al., Measuring and Managing Credit Risk, 2004)

Ratio (Median) EBIT Interest Coverage (x) EBITDA Interest Coverage (x) Free Oper Casf Flow/Total Debt (%) Funds from Operations/Total Debt (%) Return on Capital (%) Operating Income/Sales (%) Long Term Debt/Capital (%) Total Debt/Capital (%) Number of Companies

AAA 21.4 26.5 84.2 128.8 34.9 27.0 13.3 22.9 8

AA 10.1 12.9 25.2 55.4 21.7 22.1 28.2 37.7 29

A 6.1 9.1 15.0 43.2 19.4 18.6 33.9 42.5 136

BBB 3.7 5.3 8.5 30.8 13.6 15.4 42.5 48.2 218

BB 2.1 3.4 2.6 18.8 11.6 15.9 57.2 62.6 273

B 0.8 1.8 -3.2 7.8 6.6 11.9 69.7 74.8 281

CCC 0.1 1.3 -12.9 1.6 1.0 11.9 68.8 87.7 22

Market Value Based Models

(Source: Caouette, Altman and Narayanan, Managing Credit Risk, 1999)
Probability density of future asset values SD of future asset values Net expected growth of assets Mean of Asset Value Note: SD = Standard Deviation

Market Value

Increase in servicing requirement due to ballooning term loan # of SD from Mean Shape of probability density in region of distress

EDF

Now

1 Year

Time

Debt Service Requirement

Models based on Artificial Neural Networks

A Data mining solution Multilayer Perceptron Network Model Training and Validation Handling missing data and extreme values Applications for failure prediction and rating replication

Reasons for Increased Use Credit Models

Credit analysis is expensive and slow Consolidation in the industry and lack of homogeneity in credit expertise Need for discipline in credit management and pricing Need for a common credit language Credit control -- an objective model provides a benchmark even if it gets modified using credit judgment Regulatory reasons Securitization - Credit as something to sell not something to keep.

Some Observations
Driven by historical data, limited forward looking input Do not incorporate many external factors that are not easily quantified, but are nevertheless important (e.g., management quality, corporate governance, lack of transparency in corp. structure)

Some Observations, Contd.

Market value based models:
Will generally pass through the noise and bubbles that affect equity markets and may be volatile Not entirely based on option theory EDF is an empirical estimate using historical default data and distance to default EDF tends to be directionally correct but may not necessarily be an accurate measure of default probability Debt subject to default is a heuristic approximation from the actual debt structure of the firm

Models to Measure Credit Exposure

Credit Exposure
For most cases, credit exposure is straightforward for bonds, it is the principal plus accrued interest Credit exposure in derivatives can fluctuate as a result of interest and currency rates Credit exposure may exist in insurance products either directly or indirectly

Modeling Credit exposure in Insurance Products

Typically the exposure arises because of the existence of a counterparty in an insurance transaction:
Another insurance companys policy Reinsurer Captive reinsurer Credit insurance

Usually credit risk exposure is measured by analyzing loss experience distribution

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Derivative Exposure through Time Example

Let us say in a interest rate swap you receive a fixed @ 8 percent and pay Libor If the interest rates subsequently move down, then your swap is now in the money
If the counterparty now defaults then you will need to get a new counterparty who will pay lower fixed rate. The MTM of the swap would be lost

The exposure would typically start at zero, reach a maximum and then decline to zero at maturity

Derivatives Exposure
Exposure = Current MTM + Potential Future Exposure
Start with stochastic models for interest rates Impose a correlation structure on the key rates Use Monte Carlo simulation Apply collateral, netting arrangements, guarantees Downgrade triggers are tougher to model

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Loss Given Default Models

LGD Models Corporate Bonds

Corporate bonds LGD models are based on baseline recovery by rating, industry, seniority, debt cushion
A forward looking component may be superimposed based on industry / economic outlook An idiosyncratic component based on the issuers unique position (if true) Market Value versus Ultimate recovery

LGD of holding company and subsidiary debt is a complex issue involving both corporate structure and capital structure.

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Factors Affecting Recovery

Initial Rating & Prior Rating Collateral Seniority Debt Cushion Position in the corporate hierarchy Industry Timing in the the economic cycle

Initial Rating and LGD

(Source: Recoveer Rates on Defaulted Corporate Bonds and Preferred Stocks, Moodys, 2003, adjusted)

RATING Aaa Aa A Baa Ba B Caa-C

LGD % 42.0 45.6 40.1 54.3 58.9 65.6 78.6

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Prior Rating and LGD

(Source: Recoveer Rates on Defaulted Corporate Bonds and Preferred Stocks, Moodys, 2003, adjusted)

Prior Rating 1 YP Aaa Aa A Baa Ba B Caa-Ca

2 YP 0.0 4.6 48.7 56.7 62.3 64.1 71.6 0.0 37.9 52.9 57.7 59.7 65.0 77.6

3 YP 0.0 69.2 58.0 56.3 60.3 63.8 82.1

4 YP 3.0 55.6 55.5 59.2 58.1 64.8 72.4

5 YP 25.9 58.9 54.3 61.9 57.4 62.2 87.7

Effect of Seniority on LGD

(Source: Standard and Poors, adjusted)

Bank Debt Senior Secured Notes Senior Subordinated Notes Subordinated Notes Junior Subordinated Notes

25 Percent 35 70 75 80

Senior Unsecured Notes 55

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Industry and LGD

There are conflicting views in the variability of LGD with industry Broadly speaking, LGD on long term bonds in nonfinancial companies seems to be higher than in financial companies

Effect of Timing on LGD

(Source: Standard and Poors, adjusted) Loss Given Default Bank Debt Senior Secured Senior Unsecured Notes Senior Subordinated Notes Long Term (88-02) 42 percent 51 65 71 Stressed (98-02) 44 percent 58 75 80

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LGD Models - Municipals

Defaults on high grade municipals are comparatively rare.
Low to non-existent LGD for high grade GOs For revenue bonds, LGD is based on the capital charges applied for monoline bonds insurers and ranges from 0 to 40 percent.

LGD Models - Sovereigns

Currently not enough data exists on recovery rates on sovereign defaults.
LGD is assumed to be close to zero for OECD countries For other countries LGD is subjectively based on base recovery rates on defaulted sovereigns adjusted with corporate bond recovery experience

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LGD For Sovereigns - Example

Risk Rating 1 2 3 4 5 6 Developed Country 100 % 100 ----Developing Country 100 % 67 61 47 38 35

LGD Models Structured Assets

There is no simple approachbecause the loss on any CDO tranche depends on the interplay of many factors Currently exploring BET, Lognormal, Fast Fourier Transform techniques worst-Var using a composite stressed case tail distribution Like in any portfolio model, default correlation is difficult to measure and model Is a AAA-rated corporate bond of the same risk as a AAArated CDO tranche?

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LGD Models -- Where are we?

Important part of the credit analysis but suffers from
Lack of good data Unavailable links to other variables such as seniority, economic environment Main sources of data are rating agencies (Bonds) and SOA (private placements)

Concluding Remarks
Credit models have had the most impact through the internal rating systems Other models while important, do not yet play a central role Data lags behind theory

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