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Risk‐Based Capital and Credit Insurance Portfolios
Author(s) -
Lai Van Son,
Soumaré Issouf
Publication year - 2010
Publication title -
financial markets, institutions and instruments
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.386
H-Index - 23
eISSN - 1468-0416
pISSN - 0963-8008
DOI - 10.1111/j.1468-0416.2009.00153.x
Subject(s) - credit risk , capital adequacy ratio , business , capital requirement , risk adjusted return on capital , actuarial science , loan , economic capital , probability of default , economics , finance , financial capital , capital formation , human capital , profit (economics) , incentive , microeconomics , economic growth
This paper analyzes the risk‐management practices of a vulnerable credit insurer by studying the effects of time‐varying correlations, asset risks and loan maturities on the risk‐based capital that backs credit insurance portfolios. Since asset correlations may change over a business cycle, we have analyzed these effects by means of a one‐factor Gaussian stochastic model as part of an extended contingent claims analysis. Our results show the need to account for cyclical changes to correlations in the pricing of credit insurance. When compared with the reserve of risk‐based capital recommended by the Basel II Internal Ratings‐Based (IRB) approach, our model provides a better capital buffer against extreme credit losses, especially in times of recession and/or in a risky business environment. Using a risk‐adjusted performance metric (RAPM), we find insurers perform better when insuring relatively short‐term loans. We also make several policy recommendations on creating a reserve of risk‐based capital to protect against possible loan losses.