Management of credit risk for financial instruments

Financial institutions (banks, insurance companies, investment entities) should have a management process in place to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred.

The sound practices should specifically address the following areas:

  1. establishing an appropriate credit risk environment;
  2. operating under a sound credit-granting process;
  3. maintaining an appropriate credit administration, measurement, and monitoring process; and
  4. ensuring adequate controls over credit risk.

Although specific credit risk management practices may differ among financial institutions depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in Basel Committee documents.

The following are illustrative disclosures of explanations of the risk management processes in place in the reporting entity.

IFRS Link

Explanation

IFRS 7 33 (b),

IFRS 7 35B (a)

The insurer has a credit risk policy in place that is approved by the Executive Risk Committee and sets out how credit risk is measured, managed, monitored and reported. The oversight of the execution of the credit risk policy is delegated to the credit risk committee. The execution itself is performed by the credit risk department and asset managers. The credit risk policy is evaluated at least on a yearly basis and adjusted as approved by the Executive Risk Committee if needed. The credit risk department reports to the credit risk committee on a quarterly basis.

The insurer manages credit risk by setting credit risk limits within the risk appetite set by the Executive Risk Committee. Asset managers are to operate within these credit limits, and the credit risk department monitors whether credit limits are exceeded.

Credit limits are set for individual counterparties and geographical and industry concentrations. The insurer’s policy is to invest in high quality, liquid (i.e. investment grade) financial instruments. If credit risk deteriorates significantly, it is the insurer’s policy to sell these investments and to purchase high quality, liquid financial instruments in return. The insurer does not use credit derivative instruments to manage credit risk.

Model for expected credit loss

IFRS 9 outlines a three-stage model for impairment based on changes in credit quality since initial recognition as summarised below:

  • A financial instrument that is not credit-impaired on initial recognition is classified in Stage 1 and has its credit risk continuously monitored by the insurer.
  • If a SICR since initial recognition is identified, the financial instrument is moved to Stage 2 but is not yet deemed to be credit-impaired.
  • If the financial instrument is credit-impaired, the financial instrument is then moved to Stage 3.
  • Financial instruments in Stage 1 have their ECL measured at an amount equal to the portion of the lifetime ECL that results from default events possible within the next 12 months. Instruments in Stages 2 or 3 have their ECL measured based on the ECL on a lifetime basis.
  • A pervasive concept in measuring the ECL in accordance with IFRS 9 is that it should consider forward-looking information.
  • Purchased or originated credit-impaired financial assets are those financial assets that are credit-impaired on initial recognition. Their ECL is always measured on a lifetime basis (Stage 3).

The following diagram summarises the impairment requirements under IFRS 9 (other than purchased or originated credit-impaired financial assets):

See also: Definition of default and credit-impaired assets

IFRS 7 35G (a)

Management of credit risk for financial instruments

Management of credit risk for financial instruments

Management of credit risk for financial instruments

Measuring ECL – Explanation of inputs, assumptions and estimation techniques

The ECL is measured on either a 12-month (12M) or lifetime basis depending on whether a SICR has occurred since initial recognition or whether an asset is considered to be credit-impaired. The ECL is the discounted product of the probability of default (PD), Exposure at default (EAD) and loss given default (LGD), defined as follows:

  • The PD represents the likelihood of a borrower defaulting on its financial obligation (as per definition of default and credit-impaired assets above), either over the next 12 months (12M PD) or over the remaining lifetime (Lifetime PD) of the obligation.
  • The EAD is based on the amounts the Group expects to be owed at the time of default, over the next 12 months or over the remaining lifetime.
  • The LGD represents the insurer’s expectation of the extent of loss on a defaulted exposure. The LGD varies by type of borrower, type and seniority of claim and availability of collateral or other credit support. The LGD is expressed as a percentage loss per unit of exposure at the time of default (EAD). The LGD is calculated on a 12M or lifetime basis, where the 12M LGD is the percentage of loss expected to be made if the default occurs in the next 12 months and the lifetime LGD is the percentage of loss expected to be made if the default occurs over the remaining expected lifetime of the loan.

The ECL is determined by projecting the PD, LGD and EAD for each future month and for each individual exposure or collective segment. These three components are multiplied together and adjusted for the likelihood of survival (i.e. the exposure has not prepaid or defaulted in an earlier month).

This effectively calculates an ECL for each future month, which is then discounted back to the reporting date and summed. The discount rate used in the ECL calculation is the original EIR or an approximation thereof.

IFRS 7 35G (a)(i)

Management of credit risk for financial instruments

The Lifetime PD is developed by applying a maturity profile to the current 12M PD. The maturity profile looks at how defaults develop on a financial instrument portfolio from the point of initial recognition throughout the lifetime of the financial instrument. The maturity profile is based on historical observed data and is assumed to be the same across all assets within a portfolio and credit grade band. This is supported by historical analysis.

Forward-looking economic information is also included in determining the 12M and lifetime PD, EAD and LGD. These assumptions vary by product type.

The assumptions underlying the ECL calculation are monitored and reviewed on a quarterly basis.

IFRS 7 35G (c)

There have been no significant changes in estimation techniques or significant assumptions made during the reporting period. Management of credit risk for financial instruments

Leave a Reply

Your email address will not be published. Required fields are marked *