This weekend financial media was concentrating on the credit event of Greece.Greece has officially defaulted on its debt to private lenders. It was an “orderly” default, negotiated rather than simply announced. This formal default on about $100 billion triggered payment of $3 billion in credit-default swaps.
One of the washington post tried to revealed that Insurance and CDS are different, CDS should never be treated like insurance, as its Mandatory for the insurance company to make reserve against insurance that it has issued on the other hand Credit Default swaps (CDS) is naked gambling.
The issue isn’t whether CDS contracts are “insurance”. After all, one can purchase CDS on Corporation X without having an insurable interest in the financial health of Corporation X. It’s just a naked bet that Corporation X will fail like gambling in a casino. That’s not insurance, which protects and indemnified the policyholder for losses incurred.
The issue is how to ensure that the writers of “insurance” or “protection” in CDS contracts have the ability to meet their obligations should the contract go sour. AIG didn’t. One can either treat CDS as insurance and force the protection writer to set aside reserves for potential claims (from the premiums received from the customer), OR one can force the protection writer to post margin at the end of each trading day to account for fluctuations in the risk spreads of Corporation X.
The argument above is not about CDS should or shouldn’t be an insurance contract, it is that the regulators of banks and insurance companies did horrible jobs and the rules help avoid those regulations that are in place, far too easily.