Credit charges (insurance)

What “credit charges” mean in insurance regulation

Credit charges are amounts insurers must set aside to protect against the risk that another party will fail to meet its financial obligations. This ensures insurers have enough funds to pay policyholders when needed.

Where credit charges apply

Credit charges apply in many situations where insurers rely on things other than cash on hand to meet financial commitments. This includes the risk of a reinsurer failing to pay its share of claims, or brokers, agents, and policyholders owing the insurer money. They also cover investments such as bonds and other financial assets that carry a risk of loss due to default.

To determine how much capital is required, regulators use credit risk factors: percentages that reflect the likelihood of default. Credit risk charge is then calculated by applying the credit risk factors to the risk exposures. Higher risk exposures will result in higher credit charges, meaning insurers must hold more capital to offset them.

Example of credit charges in action

Imagine an insurance company that relies on a reinsurer to cover part of its claims. If the reinsurer has a strong financial rating, the insurer faces a lower risk that the reinsurer won’t pay when needed. In this case, the insurer would apply a lower credit risk factor, resulting in a lower credit charge and therefore it would have to hold less capital to offset that particular risk.

However, if the company relies on a reinsurer with a weaker credit rating, the risk of default is higher. The insurer must then apply a higher credit risk factor resulting a higher credit charge, and would need to hold more capital for the risk of default. This ensures that if the reinsurer fails to pay its share of claims, the insurer can still meet its obligations to policyholders without disruption.