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The look similar, but are different

Difference between credit default swaps (CDS) and insurance. They look similar, but are different

Most of the people think that credit default swaps (CDS) and insurance is the same. But in-fact CDS is a “sort of” insurance and not insurance in complete sense. We will first look at what a CDS is. A CDS is a financial instrument or arrangement that protects buyers of the CDS from risk of default by its lenders. The seller of the CDS can be large financial institutions or insurers. Let me give two simple examples to make it easy to understand for you.

There are three actors in this story: The bank (Buyer of CDS), the homeowner, and the financial institution (Seller of CDS). The home owner took a home loan from the bank. The owner is paying its monthly installments. However, there is no guarantee that the home owner can keep paying the loan installments. The loan default can have multiple reasons and we won’t go into that domain. So now the financial institution came into the picture and says to bank that it can take guarantee that payment to the bank won’t stop. It is s type of insuring the loan amount. The financial institution asks some amount of money for this protection. And so, an instrument is designed to protect bank from default risk.

There are again three actors in this story: Company A, a lending institution (Buyer of CDS), and a financial institution (Seller of CDS). Now, company A is in need for money, but they don’t have good credit rating. The lending institution can lend company A the money, but the management of the lending institution has rule that it can only lend to companies with high credit ratings. The financial institution with highest credit rating came into picture and say to the lending institution that it can guarantee that company A will pay off the debt. The lending institution asks some fees for this guarantee. Now lending institution can lend money to company A, as it is protected by highest rating financial institution.

We see in the above two example that a CDS works like an insurance, but technically it is not an insurance. Let us look at different aspects that differentiates it from insurance.

  1. CDS doesn’t have the requirement of insurable interest. Investor can buy CDS even if they are not actually exposed to that default risk. Compare this with insurance; you can buy insurance if you are actually exposed to that risk. If you have a home, you can buy insurance for that property, but can’t buy insurance for others’ property. CDS can be bought by investors even if they don’t have direct exposure of default risk.
  2. Insurance requires valuation of the assets that has to be insured. However, a CDS Seller looks at the creditworthiness of the Buyer and market price of the CDS Transaction
  3. In case of an insurance, if an event occurs, the insureds have to show the proof the event resulted in loss. There would be an investigation to determine if there is any fraud involved. However, in case of CDS, a default results in payment on CDS transaction
  4. Tax treatment: Company purchasing insurance on its assets may be able to show premium payment as cost of doing business, but a CDS buyers can’t claim such tax deduction.
  5. Insurance is for pure risk and not for speculative risk. Pure risk is where you have a loss or no loss, there can’t be gain. Whereas speculative risk is where you have chances of gain in the transaction. CDS instrument is also bought and sold keeping profit agenda in mind. Buyers even don’t have to own the debt for which the contract is made.

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