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Continuous Monitoring: Does Credit Risk Vanish?1

Published online by Cambridge University Press:  09 August 2013

Snorre Lindset  and
Svein-Arne Persson
Snorre Lindset
Affiliation:
Trondheim Business School, HIST avdeling TØH, 7004 Trondheim, Norway., E-Mail: [email protected], Telephone: +47 73 559 978, Facsimile: +47 73 559 951
Svein-Arne Persson
Affiliation:
Norwegian School of Economics and Business Administration, Department of Finance and Management Science, Helleveien 30, 5045 Bergen, Norway., E-Mail: [email protected], Telephone: +47 55 959 547, Facsimile: +47 55 959 650
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Abstract

We present a model for pricing credit risk protection for a limited liability non-life insurance company. The protection is typically provided by a guaranty fund. In the case of continuous monitoring, i.e., where the market values of the company's assets and liabilities are continuously observable, and where the market values of assets and liabilities follow continuous processes, regulators can liquidate the insurance company at the instant the market value of its assets equals the market value of its liabilities, implying that the credit protection is worthless. When jumps are included in the claims process, the protection provided by the guaranty fund has a strictly positive market value. The ability to continuously monitor asset prices with continuous sample paths eliminates economic losses from default. Our analysis suggests that economic losses from default stem from jumps in continuously observed asset prices and/or that asset prices are not continuously observed.

Keywords

Credit risk for non-life insurersguarantee fundcontinuous monitoringbarrier options
Type
Research Article
Information
ASTIN Bulletin: The Journal of the IAA , Volume 39 , Issue 2 , November 2009 , pp. 577 - 589
Copyright
Copyright © International Actuarial Association 2009

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Footnotes

1

Earlier versions of this paper have been presented at the FIBE conference in Bergen, January 2007, at the Astin Colloquium in Orlando, Florida, USA, June 2007, at faculty seminars at the Insurance and Risk Management Department at the Wharton School, University of Pennsylvania, the Department of Finance and Management Science, Norwegian School of Economics and Business Administration, and the University of Amsterdam. The paper was partially written while Lindset was a visiting scholar at the Insurance and Risk Management Department at the Wharton School, University of Pennsylvania. The authors would like to thank Knut Aase, Neil Doherty, Antoon Pelsser, and two anonymous referees for comments.

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