Question ID: 2317
Regulation Reference: (EU) No 2015/35 - supplementing Dir 2009/138/EC - taking up & pursuit of the business of Insurance and Reinsurance (SII)
Topic: Solvency Capital Requirement (SCR)
Article: 179 & 189
Date of submission: 26 Jul 2021
What is the definition of a “credit derivative” within the meaning of Article 179 of EU CDR 2015/35 in relation to a derivative referencing a bond or loan but not qualifying as a “credit derivative”? Article 179 of EU CDR 2015/35 sets out the capital requirements for “credit derivatives” as part of the Spread risk sub-module of the Market risk module. Article 189 of EU CDR 2015/35 sets out the capital requirements for counterparty default risk and defines Type 1 exposures, among others, in paragraph 2 point (f) as derivatives other than credit derivatives covered in the spread risk sub-module. If an insurer enters into the following contracts for risk taking purposes, could you clarify which of these contracts would fall under Article 179 and which would fall under Article 189 for the purpose of determining the SCR: 1) Credit Default Swap (“CDS”) contract: A typical CDS contract only triggers a contractual loss for the protection seller (or CDS buyer) when a defined event of default occurs with respect to a specified reference asset, resulting in a payment to the protection buyer. For standardized CDS contracts referencing “on-the-run" issuers, a secondary market exists and such CDS contracts may themselves be subject to spread risk. The credit spread of bonds or loans of the underlying issuers, however, are not relevant in respect to the pay-out profile of a CDS contract. 2) Total Return swap (“TRS”) contract referencing a bond or loan: a TRS contract replicates the market value of a reference bond or loan and the contract’s pay-out profile does not directly depend on an event of default of the reference asset but rather, on the change in market value of the reference asset. 3) Forward contract referencing a bond or loan: the pay-out-profile and the pricing function of a forward contract references the market value of the reference asset; the relationship is linear with a Delta of 1. 4) Call or Put Option referencing a bond or loan: the pay-out-profile and the pricing function of a call or put option references the market value of the reference asset; the relationship is non-linear with a Delta of smaller than 1. Please also provide guidance if the categorization of a Call or Put Option would change if the option gets knocked-out in case of an event of default of the reference asset.
Background of the question
Our client is an asset management firm that manages alternative investment funds that can enter into above-mentioned derivatives. As fund investors include insurance companies who are subject to Solvency II, and our client provides look-through reporting to such insurance companies, our client would like to understand if the above-mentioned derivatives would fall into the scope of Article 179 or the scope of Article 189 of EU CDR 2015/35.