Modelling of Credit Structures and Securitisations within a Reservoir Non-Life Insurance Framework
Although the use of credit structured products and securitisations experienced a contraction after the catastrophic events of the 2007-2008 credit crisis, such structures have remained as a major source of funding in the financial system. Yet, there is still no general agreement about the best modeling techniques. Main players in the industry - such as, credit rating agencies, investment banks, and institutional investors - have tended to rely on valuation methods based on complex and opaque mathematical modeling, strongly dependent on qualitative assessment, and thus prone to sudden and unexpected adjustments - reflecting changes in the underlying working assumptions. This has been raised as a main factor causing the crisis episode.
Alternatively, a theoretical setting is proposed to characterise the problem of the management of credit structures and securitisations within a reservoir non-life insurance framework. For this purpose, the view of a certain institution acting as a special purpose vehicle (SPV) is adopted, who commits to execute a series of regular payments to investors, funded with the flow of random profits produced by a pool of risky assets pledged as collateral. Each time the assets pool results in a portfolio loss, the institution must rely on short-term debt to remain solvent, though the nominal value of leverage cannot surpass a maximum level contractually established at issuance. When the required leverage surpasses the maximum level specified in the contract, the structure enters into default. Thus, the problem of the management of credit structures can be described as a standard reservoir problem with stochastic inflow and regular outflow.