Econometrics and Finance Seminar: Olivier Le Courtois

Credit Benchmarking, Risk Premium Adjustment Factors, and Credit Solvency Capital Requirements. A Recovery-based Approach

Olivier LE COURTOIS, EMLyon Business School

(with Jeremy Allali and Mohamed Majri)

This article constructs a recovery-based framework for computing the credit Solvency Capital Requirements of insurers under the constant position paradigm. Although this framework is most suited under the Solvency 2 regulation, it also provides concepts that can be useful under the Basel regulation. After a brief survey of the extant technology on rating transitions and default probabilities, the paper provides new results on risk premium adjustment factors. Then, three different procedures for reconstructing constant position market-consistent histories of credit portfolios from quoted Merryll Lynch indices are given. The reconstructed historical credit values are modeled via a mixed empirical-Generalized Pareto Distribution (GPD) dynamics and a detailed 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.