7.5.1. Credit risk and concentration risk

Credit risk is the risk of a loss or adverse change in the financial situation resulting from fluctuations in the trustworthiness and creditworthiness of issuers of securities, counterparties and all debtors, materializing through a counterparty’s default on a liability or an increase in credit spread. This definition also includes credit risk in financial insurance.

Credit risk in the PZU Group includes:

• credit risk in banking activity – credit risk resulting from activity in the banking sector, associated mainly with the possibility that a debtor or borrower defaults on their obligations;
• credit risk in financial insurance – credit risk resulting from activity in the financial insurance sector, related mainly to the possibility that a PZU Group customer defaults on its obligations to a third party, or a debtor/borrower defaults on its obligations to a PZU Group customer; this threat may result from failure to complete an undertaking or adverse influence of the business environment;
• credit spread risk – the possibility of incurring a loss due to a change in the value of assets, liabilities and financial instruments resulting from a change in the level of credit spreads as compared to the term structure of interest rates of debt securities issued by the State Treasury or fluctuations of their volatility;
• counterparty default ris – the possibility of incurring a loss as a result of unexpected default of counterparties and debtors or deterioration of their credit rating.

Concentration risk a risk stemming from the failure to diversify an asset portfolio or from large exposure to the risk of default by a single issuer of securities or a group of related issuers.

Exposure to credit risk in the PZU Group arises directly from banking,  investment activities, activity in  the  financial insurance and guarantee segment, reinsurance agreements, and bancassurance operations. The PZU Group distinguishes the following kinds of credit risk exposure:

• risk of a customer defaulting against the PZU Group under contracted credits or loans (in banking activity);
• the risk of bankruptcy of the issuer of financial instruments invested in or traded by the PZU Group, such as corporate bonds;
• the risk of counterparty default, for example in reinsurance or OTC derivative instruments and bancassurance activities.
• the risk of PZU Group customer defaulting against a third party, for example in insurance of cash receivables, insurance guarantees.

7.5.1.1. Concentration risk arising out of lending activity

This section presents information related to lending activity of PZU Group’s banks

To prevent adverse events that could result from excessive concentration, both Pekao and Alior Bank mitigate the concentration risk by setting limits and applying concentration standards arising from both external and internal regulations. They include the following:

• rules for identifying areas where concentration risk arises in credit activity;
• taking concentration into account when estimating internal capital;
• the process of setting and updating limit levels;
• the process of managing limits and defining actions taken if the permitted limit level is exceeded;
• concentration risk monitoring process, including reporting;
• oversight over the concentration risk management process.

In the process of setting and updating concentration limits, the following information is taken into account:

• information on the level of credit risk of limited portfolio segments and their impact on realization of assumptions related to risk appetite in terms of credit portfolio quality and capital position;
• sensitivity of limited portfolio segments to changes in the macroeconomic environment, assessed in regular stress tests;
• reliable economic and market information concerning each exposure concentration area, especially macroeconomic and industry ratios, information on economic trends, including the projections of interest rate levels, exchange rates, political risk analysis, ratings of governments and financial institutions;
• reliable information about the economic situation of companies, industries, branches, economic sectors, general economic information including news on the economic and political situation of countries, as well as other information needed to evaluate concentration risk;
• interactions between different kinds of risk, i.e. credit, market, liquidity and operational risk.

Risk analysis is performed using both an individual and a portfolio approach. Measures are undertaken to:

• minimize credit risk for an individual loan with the assumed level of return;
• reduce overall credit risk arising from a specific credit portfolio.

In order to minimize the risk level of a single exposure, the following is assessed every time when a loan or other credit product is granted:

• reliability and creditworthiness, including detailed analysis of the source of exposure repayment;
• collaterals, including review of their formal, legal and economic status, having regard to the loan to value (LTV) adequacy ratio.

In order to enhance control over the risk of individual  exposures,  customers are monitored regularly and appropriate measures are taken if increased risk factors are identified.

In order to minimize credit risk arising from a particular portfolio:

• concentration limits are set and tracked;
• early warning signs are monitored;
• the credit portfolio is monitored regularly, with particular supervision of material credit risk parameters;
• regular stress tests are carried out.

7.5.1.2. Credit risk in banking activity

Risk assessment in credit process

The provision of credit products is accomplished in accordance with loan granting methodologies appropriate for a given client segment and type of product. The internal rating process in both banks constitutes a significant part of assessing credit risk of both the client and the transaction. It is an important step in the credit decision-making process for new loans and for changes of lending terms, and in monitoring loan portfolio quality. Each bank has developed its own models used in the client creditworthiness assessment process, which must be completed before a credit decision is made. The models are based on external information and on internal data. Credit products are granted in the banks in accordance with the operating procedures, whose purpose is to set out the proper steps that must be taken in the credit process, identify the units responsible for those activities and the tools to be applied.

Credit decisions are made in accordance with the existing credit decision system (with decision-making powers at specific levels matching the risk level of a particular client and transaction).

In order to conduct regular assessment of accepted credit risk and to mitigate potential losses on credit exposures, the client’s standing is monitored during the lending period by identifying early warning signals and by conducting regular individual reviews of credit exposures.

To minimize credit risk, security interests are established in line with the level of exposure to credit risk, considering recovery rate from a specific type of collateral. The establishment of a security interest does not waive the requirement to examine the client’s creditworthiness.

Collateral is taken to secure repayment of the loan amount with due interest and costs if the borrower fails to settle its due debt within the dates stipulated in a loan agreement and restructuring activities are not successful. Accepted forms of collateral include: guarantees, sureties, account freezes, registered pledges, transfers of title, assignments of receivables, assignment of credit insurance, promissory notes, mortgages, powers of attorney to bank accounts and security deposits (as special forms of collateral). The assets constituting collateral are reviewed in the credit process in terms of their legal capacity to establish effective security interest and also the recoverable amount in a possible enforcement procedure.

The financial effect of the established collateral for the portfolio of exposures measured individually with recognized impairment as at 31 December 2020 is PLN 2,658 million (as at 31 December 2019: PLN 2,902 million). This is an amount by which the level of the required impairment losses for this portfolio would be higher if no discounted cash flows obtained from collateral were taken into account in their estimation.

In connection with the COVID-19 pandemic and the increased credit risk, in 2020 banks introduced limitations in acceptance of new exposures and close monitoring of exposures potentially at risk. The limitations of new sales pertain to, among others, selected industries or countries particularly exposed to the negative economic effects of the pandemic.

Scoring and credit rating

The rating scale differs by bank, client segment and transaction type. The following tables present the quality of credit portfolios for exposures covered by internal rating models. Because of the different rating models employed by Pekao and Alior Bank, the data are presented for each of the banks separately.

Pekao

Alior Bank

7.5.1.3. Application of forbearance

Forbearance is used if a threat arises that a client may default on the terms of a contract because of the financial difficulties, including problems with the service of debt. In such a situation, the terms and conditions of the agreement can be modified to ensure that the borrower is capable of servicing debt. Changes in terms and conditions of contracts may include: reduction of interest rates, principal installment amounts, accrued interest, rescheduling of principal or interest payments.

The PZU Group defines the list of forbearance arrangements comprising in particular:

• extending the lending period (in the form of an annex to the agreement) or signing a restructuring agreement (in the case of debt that is fully overdue), which results in reduction of the principal and interest installment;
• granting a repayment grace period;
• change of terms and conditions of the agreement allowing for lower interest or principal repayments;
• agreement subject to refinancing.

The PZU Group identifies a significant increase in the credit risk of assets for which forbearance modifications have been applied for the purpose of assessing impairment in accordance with IFRS 9.

In the case of granting a loan moratorium period or other measures to ease the effects of the COVID-19 pandemic, the PZU Group applies an approach consistent with the regulatory guidance in this respect and does not classify such items automatically as forborne.

7.5.1.4. Credit risk arising out of investing activity

The management principles for credit risk arising from investing activity in the PZU Group are governed by a number of documents approved by supervisory boards, management boards and dedicated committees.

Credit risk exposures to respective counterparties and issuers are subject to restrictions based on exposure limits. The limits are established by dedicated committees, based on the analyses of risks associated with a given exposure and taking into account the financial standing of entities or groups of related entities and the impact of such exposures on the occurrence of concentration risk. Qualitative restrictions on exposures established by individual committees in accordance with their powers form an additional factor mitigating the credit risk and concentration risk identified in investment activities.

The limits refer to exposure limits to a single entity or a group of affiliated entities (this applies to both credit limits and concentration limits). The use of credit risk and concentration risk limits is subject to monitoring and reporting. If the limit is exceeded, appropriate actions, as defined in internal regulations, are taken.

Credit risk assessment of an entity is based on internal credit ratings (the approach to rating differs by type of entity). Ratings are based on quantitative and qualitative analyses and form one of the key elements of the process of setting exposure limits. The credit quality of counterparties and issuers is regularly monitored. One of the basic elements of monitoring is a regular update of internal ratings.

Risk units identify, measure and monitor exposure to credit risk and concentration risk related to investment activity, in particular they give opinions on requests to set exposure limits referred to individual committees.

Information on the credit quality of assets related to investing activity is presented in section 38.

Exposure to credit risk

The subsequent tables present the exposure to credit risk for credit risk assets in the various categories of Fitch ratings (if there is no Fitch rating then a Standard&Poor’s or EuroRating’s rating is used instead). The credit risk exposure arising from repo transactions is presented as an exposure to the issuer of the securities taken as collateral.

The table does not include loan receivables from clients and receivables due under insurance contracts. This ensues from the considerable distribution of these asset portfolios meaning, among others, that a significant portion of the receivables comes from entities and private individuals that do not have ratings.

7.5.1.5. Reinsurer’s credit risk in insurance activity

PZU Group enters into proportional and non-proportional reinsurance contracts aiming to reduce liabilities arising from its core business. Reinsurance is exposed to credit risk associated with the risk that a reinsurer default on its obligations.

Assessment of reinsurers’ creditworthiness is conducted based on market data, information obtained from external sources and also based on an internal model. The model divides reinsurers into several classes, depending on the estimated risk level. A reinsurer will not be accepted if its risk is higher than a pre-defined cut-off point. The acceptance is not automatic and the analysis is supplemented by assessments by reinsurance brokers. In the credit risk monitoring process, this assessment is updated on a quarterly basis.

The following tables present the credit risk of the reinsurers that cooperated with PZU Group companies.

Counterparty risk related to reinsurance is mitigated by the fact that the PZU Group cooperates with numerous reinsurers with reliable credit ratings.

7.5.1.6. Risk concentration in credit risk

The following table presents the concentration of PZU Group’s balance-sheet and off-balance-sheet exposures using the sections of the Polish Classification of Business Activity (PKD):

• exposure to financial investments such as equity instruments, debt securities, loans granted buy-sell-back transactions, bank accounts and term deposits;
• amounts of extended insurance guarantees;
• liability limits for insurance of receivables;
• value of loans (balance-sheet and off-balance-sheet exposure without interest, collected fees and impairment losses) less security deposits paid in cash.