Lila Granda is the Head of Credit & Political Risk for Product Underwriting at Zurich North America. While at Zurich, Lila also has served as Credit & Political Risk Manager for the Americas, based in Washington, D.C. and Credit & Political Risk Manager for Continental Europe based in Barcelona, Spain. The comments and views expressed in this interview are those of Ms. Granda and do not necessarily reflect the views of her employer, Zurich American Insurance Company. Her observations are the result of her cumulative experience.
Felton (Mac) Johnston (FMJ): Tell us a little about what Zurich Credit & Political Risk does to identify, measure, and manage correlation risk. Is there a model?
Lila Granda (LG): At Zurich, we review our portfolio frequently and one of our objectives in reviewing the portfolio is to identify trends. At least quarterly, we take a look at what we have on the books and look for trends that may include correlations. Also, we take a look at any claims experience or developing claims to see if there are any trends there. This is where we might see certain correlations among risks. The Arab Spring is a well-known case of correlation risk on a regional basis. That’s not something that I necessarily anticipated, though it makes sense in hindsight. We have also noticed some correlations with respect to commodity price movements. We manage these by considering limits on overall exposure where we believe there are potential risk correlations, as well as through pricing.
FMJ: How does correlation risk figure in your pricing? In portfolio management?
LG: Correlations are certainly factors that our actuaries take into consideration when constructing models. I think correlations are a bit harder to quantify for political and trade credit risks than for other lines of business. If we can identify some correlation trends or factors that we have confidence in, we can formally account for them in our pricing models. This can be very helpful, for example, in pricing multi-country equity policies where we think there might be correlations associated either with the country risks within the portfolio or perhaps the nature of the business that we are insuring. In terms of managing on a portfolio basis, we have mostly focused on identifying sectors, such as the financial sector, where there may be a correlation or contagion of risk: if one bank falls, others may go with it. We determine whether we want to limit exposure to an overall sector—rather than, in this example, just bank by bank—in order to manage our risk.
FMJ: I understand that your own approach to correlation risks is evolving. What kinds of correlation risks might you be focusing on in the future?
LG: We will continue to deepen our understanding of how correlation might occur on the regional level, such as among countries. This goes back to the Arab Spring example. We already do this on a case by case basis with particular economic sectors, such as the financial sector. I think energy and food commodity sectors would be interesting to look at in more depth.
FMJ: You mention major commodity (food, energy) price movements. What are some examples of how these are—or might be—correlated?
LG: We work in emerging markets with a number of countries that are dependent on the commodities they sell. They may not have particularly well-diversified economies. Falling prices for energy products, such as oil and coal, have impacted certain countries disproportionately as well as certain producers within those countries. With countries like China reducing amounts of commodities that they buy (for example, coal), that has an impact. This can be a major problem for countries like Angola or Indonesia, which were benefiting from Chinese demand. In the case of raw materials, the countries that produce these commodities may already be somewhat concentrated by region. The falling prices end up putting greater pressure on government finances, possibly affecting the ability of a government to pay its debts. This, of course, impacts country risk, credit risk for trade credit, and political risk for non-honoring of sovereign obligations and currency inconvertibility. It can increase other political risks if the loss in income means the government can’t support its population with services. Maybe there’s rioting in the streets. Maybe a more populist government comes in, which could increase the risk of government interference or expropriation. The correlation here wouldn’t necessarily be regional, but it would be a correlation among those countries around the globe with a high dependency on certain commodities for their income.
In 2007, prices of food commodities were rising rapidly, creating a sense of food insecurity that particularly affected developing countries. This led a number of countries, globally, to impose export controls. I would see this as an example of correlation based on economic sector, and one that spans regions.
FMJ: Some kinds of correlations may not be addressed in your overall pricing and portfolio management models or approaches, but may be identified when you are considering individual cases. What are some examples of these?
LG: One of the risks we cover is non-honoring of government obligations. If you were looking at an individual risk of Angola repaying on a debt, for example, you would recognize the importance of oil exports on the economy of Angola and the potential impact of declining oil prices on the ability of Angola to pay any kind of debt. You would want to look at these risks even if your repayment was associated with the construction of a hospital, completely unrelated to oil. You would also consider the impact of declining demand for oil from a major buyer such as China. Another example might be a trade credit risks for a coal producer. We have seen some emerging market producers of commodities like coal that are highly leveraged and may be expecting a certain coal price or certain level of demand. When these don’t turn out the way they had forecast, that can create a squeeze on the ability to pay.
FMJ: Is financial contagion a correlation risk that you address? How? Is your view of financial correlation limited to relationships between banks—in one country or across countries—or does it include borrowers as well?
LG: We address the risk of financial contagion with a particular view to the banking sector. This can be an analysis within a country, if we feel that the banking sector there is weak and especially reliant on the sovereign for support. But there can also be correlations among countries. In certain countries, the banking sector may be particularly reliant on short term inflows of money from overseas, which can dry up quickly for many reasons. One way that we can manage these risks is by establishing limits on exposure to the sector within a particular country or across the portfolio. Of course, if a banking sector is weak or weakened, then that can affect local borrowers that are reliant on bank financing. The analysis of those borrowers and their susceptibility to bank financing risk is done more on a transaction-by-transaction basis.
FMJ: Other than pricing and reinsurance, what measures can be taken to manage correlation risk?
LG: Exposure limits.
FMJ: Do factors such as cyber security and epidemics have political and trade credit correlation implications?
LG: We are always trying to think about emerging risks and how they may affect our book. We have thought about this with Ebola. Especially in emerging markets, epidemics could lead to political instability, particularly if the response of the government is not viewed as adequate by the population. There could be political violence. There could be disruption within the government, which could lead to chaotic change of administrations or more interference with the affairs of state-owned enterprises and private companies. And anything that destabilizes the economy in a broad way can impact the creditworthiness of trade credit borrowers in that economy. With cyber risks, I would see this more on the trade credit side, where a cyber attack could have a prolonged effect on a company’s creditworthiness. While these are not direct risks to our book, they are potential risks and we need to be thinking of what impacts they might have and how we could mitigate them.
© 2015 Zurich American Insurance Company.