Are Credit Default Swaps Credit Default Insurances?

No, they are not. Although they exhibit similar cash flow patterns (economic perspective) this article argues that from a legal, accounting and regulatory perspective credit default swaps (CDS) are not considered to be an insurance contract. The protection buyer of a CDS is eligible to obtain the co...

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Bibliographic Details
Published in:Journal of applied business research 2014, Vol.30 (6), p.1819-1830
Main Authors: Schmaltz, Christian, Thivaios, Periklis
Format: Article
Language:English
Subjects:
Accounting
Cash flow
Contracts
Credit default swaps
Credit insurance
Derivatives
Economic crisis
Insurance industry
Insurance policies
Journalists
Labeling
Regulation
Risk exposure
Risk management
Sovereign debt
Structured products
Studies
Systems analysis
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Summary:No, they are not. Although they exhibit similar cash flow patterns (economic perspective) this article argues that from a legal, accounting and regulatory perspective credit default swaps (CDS) are not considered to be an insurance contract. The protection buyer of a CDS is eligible to obtain the compensation without suffering any loss (and potentially realizing a gain) whereas insurance policies only pay out to compensate a loss (and not potentially realizing a gain). This disconnect between protection and exposure is the source for potential over-coverage. Furthermore, the concentrated set of reference entities and (interbank) counterparties as well as their tradeability make CDSs highly systemically significant products. Our conclusion is that CDSs are not default insurance policies. We propose to use default protection instead of credit default insurance to avoid the mislabelling. Furthermore, CDS have a substantial systemic risk potential which sharply contrasts to the limited systemic risk in the insurance industry. The legal classification of CDS as insurance contracts would have an enormous impact on the liquidity of CDS, as the ability of counterparties to issue and participate in CDS contracts would be limited.
ISSN:0892-7626
2157-8834
DOI:10.19030/jabr.v30i6.8900