Guy Carpenter report predicts EU regulators will work out kinks related to assessing counterparty risk in Solvency II

Global risk and reinsurance specialist Guy Carpenter said it is expecting additional changes in Solvency II that will simplify the calculation of counterparty default risk, which has been criticized for its “overly complex approach.”
A key component of Solvency II is a new capital requirement causing companies to assess and manage counterparty risk.
“This is an area of acute concern to market participants within Solvency II’s purview,” Guy Carpenter says in its September 2011 report, Succeeding Under Solvency II. “The early iterations of the new regulation have presented a very cumbersome model for determining capital requirements, but we expect this to be streamlined as the legislation moves closer to implementation.”
First, Guy Carpenter notes, the formula for measuring counterparty risk is complicated, and includes a measurement of “the risk-mitigating effect of underwriting risk of the reinsurance in consideration.” Calculating such risk for every reinsurance contract and reinsurer can be a “daunting” task, Guy Carpenter notes.
Second, the complicated formula is still largely based on ratings, which insurers already use to assess counterparty risk.
“In addition to the complexity of the calculation, the assessment of default probability remains centered on ratings, and this is not expected to change before implementation,” Guy Carpenter says. “Solvency II thus takes the basis that insurers already use to assess financial strength (ratings) and complicates the approach.
“Indeed, this approach further institutionalizes the reliance on fundamentally flawed indicators.”
Guy Carpenter says a “more robust, though admittedly still complex, approach would take a page from the Basel III proposals and establish liquidity requirements based on market instruments, such as collateralized debt securities and bonds for reinsurers that have them.”
Finally, Guy Carpenter notes the new formula for determining counterparty risk does not take into account sovereign debt. For example, there are “no risk charges for investments in sovereign debt (despite the ongoing European sovereign debt crisis).”
Guy Carpenter says European regulators are still trying to work out these and other issues related to the calculations.