On February 5, 2015, the Joint Forum, comprising insurance, banking and securities regulators  worldwide, issued a consultative document and comment solicitation titled "Developments in credit risk management across sectors: current practices and recommendations." The report offers new insights into aspects of financial regulation that could have a meaningful impact on future compliance and oversight. From an insurance company perspective, the report

  • suggests that regulators are becoming more sensitive to perceived credit risks in insurance company investment portfolios, especially from an asset-liability matching (ALM) standpoint;
  • discusses key current developments in regulation and accounting that are shaping the heightened focus on credit risk; and
  • highlights trends (such as a de-emphasis on credit rating agencies) that may not be as visible in insurance as in other sectors.

The paper was prepared jointly by the International Association of Insurance Supervisors (IAIS), the Bank for International Settlements and the International Organization of Securities Commissions (the constituent bodies of the Joint Forum) and invites comments by March 4, 2015.

Among other things, the report presents the results of a survey conducted by the Joint Forum in 2013 covering 15 regulatory bodies having jurisdiction over financial services, as well as 23 banks, insurers and securities firms. The North American, European and Asian financial sectors were all represented. The survey's goal was to "understand the current state of credit risk...management given the significant market and regulatory changes since the financial crisis of 2008."

Among other things, the report presents the results of a survey conducted by the Joint Forum in 2013 covering 15 regulatory bodies having jurisdiction over financial services, as well as 23 banks, insurers and securities firms. The North American, European and Asian financial sectors were all represented. The survey's goal was to "understand the current state of credit risk...management given the significant market and regulatory changes since the financial crisis of 2008."

The principal conclusions drawn from the survey include the following:

  • Since the financial crisis, financial firms are more likely to use stress tests and other models, and less likely to rely on credit ratings, in monitoring and managing credit exposures in their portfolios.
    • Regulators are concerned about the risks of using financial models with inapplicable parameters, incorrect model specifications or technical errors and urged caution in incorporating credit risk analysis in determining capital resources and needs.
    • Firms and regulators generally (but not universally; see below) are decreasing reliance on credit ratings, in part because of statutory and regulatory changes, particularly in the U.S.
    • ​​Financial firms have been developing more robust and sophisticated tools for measuring credit risk and spotting distressed assets.
  • Securities regulators expressed concerns over the increasing use of secured financing involving lessliquid assets, as a consequence of the "search for yield" in a low-interest-rate environment.
  • Insurers in particular must use ALM in order to make sure that cash flows on investments are adequate to support obligations under their products. ALM concerns have prompted insurers to seek higher-return investments in the years since the crisis. The report also points to pressures imposed on insurers by recent accounting reforms that may require them to price liabilities more conservatively than historically (i.e., without regard for the insurer's own credit risk). The compression of credit spreads and an increase in spread risk resulting from these trends were noted.
  • Derivatives markets and their regulators have responded to heightened credit risk exposures by increasing the use of margin.
    • The increased demand for high-quality collateral, however, puts pressure on global capacity and potentially strands capital to a greater extent than is desirable macroeconomically.
    • Furthermore, some "specialized" assets, such as airplanes, used as collateral may themselves be overvalued and insufficient to cover a counterparty default. In general, firms were more concerned than were their regulators about the uncertainties associated with valuing collateral.
  • Derivatives themselves can be used to hedge credit risk.
    • Moreover, central clearing of derivatives or other financial trades can promote stability and transparency in global markets but can also "concentrate risk" by making clearinghouse defaults more likely and potentially more consequential.

The report concludes with recommendations based on the themes outlined above, calling for (i) a mix of simple and sophisticated models in evaluating credit risk on behalf of firms with regulatory capital requirements, (ii) appropriate risk management processes at financial firms in light of the search for yield and a perceived increase in investments in riskier assets, (iii) better monitoring of available high-quality collateral for derivatives positions and (iv) regulators to be more alert to whether financial firms are "accurately capturing central counterparty exposures as part of their credit risk management."

In annexes to the report, the Joint Forum provides an overview of some of the principal statutory and regulatory changes that have emerged since the crisis, including Dodd-Frank. A discussion of insurance law highlights the role of the IAIS in formulating capital standards and codifying other "insurer core principle. "

As mentioned above, the role of credit ratings is a major point of focus in the Joint Forum's report. DoddFrank's reforms in this area (including the removal of references to such ratings in numerous federal financial laws; see § 939 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 111 P.L. 203) exemplify the skepticism toward credit ratings that emerged post crisis. The Joint Forum report describes efforts by firms and regulators to find alternative methods of measuring counterparty credit risk. Ironically, aspects of insurance regulation in the U.S. seem to buck this trend.

First, many states' insurance laws governing insurance company investments impose concentration limits on higher-risk securities based on credit ratings. (While these are nominally the insurance regulators' own proprietary credit ratings, under the auspices of the National Association of Insurance Commissioners (NAIC), ratings from the recognized rating agencies, such as Moody's or S&P, are entitled to automatic parallel NAIC ratings based on a schedule, and such rated securities need not receive any additional NAIC review. Some states, such as New York, even permit the local regulator in certain circumstances to use ratings from rating agencies that are not recognized by the NAIC; see N.Y. Ins. Law § 1404(a)(2).) The NAIC's model law on investments incorporates this rating-agency-based framework as well (see,  e.g., NAIC, Investments of Insurers Model Act (Defined Limits Version) (Model 280), § 2(ZZ) and § 2(BBB), and Investments In Medium Grade and Lower Grade Obligations Model Regulation (Model 340)).

In addition, as recently as fall 2011, the NAIC amended one of its signature model laws to increase the role of rating agencies. Specifically, the Credit for Reinsurance Model Law and its accompanying Regulation (Models 785 and 786) govern the ability of an insurer to record, as an asset on its financial statements, amounts recoverable from reinsurers. Until 2011, the model law and the vast majority of states prohibited a U.S. insurer from recording as an asset any reinsurance obtained from a non-U.S. reinsurer unless, generally, the reinsurer posted collateral sufficient to secure the subject liabilities. The 2011 amendments gave regulators the flexibility to relax or even remove these collateral security requirements for non-U.S. reinsurers deemed financially secure. The amendments contemplate the use of credit rating agency ratings (among other things) in making such determinations of financial security. With many states having already adopted the amended model, and more to come, it remains to be seen whether the new wariness toward rating agencies, as indicated in the Joint Forum report, will inform the process of awarding balance sheet credit.