Regulatory changes are also fueling this growth. Increasingly, state insurance regulators are approving replication as an investment strategy, and as they do, insurance companies can employ credit derivatives as a way to enhance investment income.

Credit derivatives are not difficult to understand and their utility, when used as an investment or risk management tool, is remarkable.

The building block of credit derivatives is called the “credit default swap,” and it is essentially a contract that transfers credit risk from one party to another. For example, an institution wishing to hedge credit risk it holds can do this by purchasing “protection”–a credit default swap contract. The seller of that protection can be an insurance company.

If there is subsequently a credit event at the underlying company, the credit default swap contract is triggered and the institution that purchased the protection can physically deliver the credit risk (usually bonds or loans) to the seller of protection in exchange for par value.

The cost of the protection is a number of basis points determined by the market of the notional value of the underlying credit. If the credit risk totals $10 million and the price of protection on the credit risk is 100 basis points, the cost of the protection per annum is $100,000. This is paid in premiums to the seller on a quarterly basis for a period of five years.

Development of credit default swaps have given rise to a thriving secondary market with buyers and sellers of protection trading these contracts. For example, Insurance Company A sells protection on $10 million worth of Company B credit risk at 100 basis points. As stated above, the price of that protection is $100,000 per annum.

In the event of positive company news, spreads on the credit default swap could tighten hypothetically to 50 basis points, meaning that the same protection could be bought for $50,000 per annum.

Most insurance companies will hold that contract and collect the premiums. However, Insurance Company A could hypothetically go into the market and purchase protection at 50 basis points, thereby locking in a 50 basis point, or $50,000 per annum gain through the offsetting trades.

Although credit derivative trades today can be executed as quickly as bond trades, this has not always been the case. Five years ago, a single trade could take days, if not weeks, to finalize. The delay was due to the dramatic difference in the documentation of each credit derivative contract.

To achieve the liquidity necessary to make this a viable and scalable market, the New York-based International Swaps and Derivatives Association, the trade association for the derivatives market, along with dealers in the market, drafted standardized language and definitions for all credit derivatives contracts.

In addition, dealers such as Morgan Stanley took this one step further by agreeing to a one-page confirmation form, based on the ISDA standards, with its major trading counter-parties.

During 2000 and 2001, there were an unusually large number of high-profile credit events. Companies such as Finova, the California utilities (Southern California Edison, and Pacific Gas and Electric) and Comdisco either missed payments on outstanding debt or filed for bankruptcy. The credit derivatives market easily digested all of these credit events.

Even the largest bankruptcy in history, Enron, itself a player in the credit derivatives market, was deftly handled. In fact, within approximately 30 days from the time Enron declared bankruptcy, nearly all outstanding credit derivative trades on Enron were settled, despite the massive amount of credit derivatives that were bought, sold and held on Enron.

Most importantly, the fears held by some that a major credit event would somehow lead to massive systemic risk due to credit derivatives were largely put to rest by the smooth and efficient handling of Enrons bankruptcy.

For years, insurance companies have invested in corporate bonds as a way to offset their annuity business and increase revenues. To increase this exposure, insurance companies buy bonds on the open market. Now, they can also do this by becoming sellers of credit default swaps.

Selling default swaps is simply another way for insurance companies to get paid a premium for taking on credit exposure. Instead of receiving payments from a bond they have invested in, the insurer receives premium payments from the buyer of the credit default swap.

Doing this has two advantages–it gives insurers access to maturities and credits that might not be available in the cash market; and the spreads on these transactions can, at times, be incrementally better than the spreads received when simply buying bonds outright in the cash market.

While selling protection is likely to be the majority of insurers usage of credit derivatives, insurers can also benefit from buying protection. In the past, when an insurer wanted to reduce credit risk exposure, it would simply sell it on the open market. Now, the option of buying protection lets an insurer get rid of the unwanted credit risk and, at the same time, retain the benefits of a long credit spread and interest rate duration.

For example, when an insurance company owns the bonds of two companies that merge, the resulting credit exposure might exceed internal risk limits. By buying protection on the excess bonds, that risk exposure is effectively taken off the books. In addition, tax consequences that might be associated with selling the bonds might be avoided.

Similarly, credit derivatives offer insurance company portfolio managers greater flexibility in managing their investment portfolios.

If a portfolio managers view of a 30-year bond he owns turns negative, for example, instead of having to sell that bond again, he can instead buy protection on the bond. This enables him to maintain a 30-year asset that might be difficult to replicate later due to supply problems. If the negative view is correct and there is a credit event, with the protection he now owns he will receive par value.

The elegance of credit derivatives is that they can be used to hedge a wide variety of credit risks, including counter-party exposure, private placement risk, lease agreements and even surety bonds. Commercial and investment banks already use credit derivatives in this manner, and it is likely that in the future, insurance companies will as well.

Like their counterparts at insurance companies, reinsurers also have accessed the credit derivatives market through single-name default swaps, or via insurance policies linked to credit derivatives.

Reinsurers especially like to act as sellers of protection on baskets of credit risk that typically contain up to 100 or more corporate American names. By taking a second loss position on these baskets, the reinsurer is effectively taking on Triple-A or higher risk.

Protection on these baskets typically will be sold for 5-to-15 basis points of the total notional value of the basket. Like insurers that are selling protection on single-name credit risk, these basket transactions give reinsurers a recurring premium payment that not only offsets the second loss insurance they traditionally write, but also puts them into a non-correlated asset class that is immune from losses in their core business.

There is little doubt that as the largest holders of credit risk, insurers and re-insurers will continue to use credit derivatives to increase their exposure to these securities.

It is likely, also, that as the comfort level with these types of products increases, the insurance industry as a whole will continue to find innovative ways to not only use credit derivatives as a mechanism for revenue enhancement, but also as a key element of their risk management strategy.

Michael Pohly and James Vore are executive directors of the Credit Derivatives Group for Morgan Stanley in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 15, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.