CDS as insurance: Leaky lifeboats in stormy seas

What market features of financial risk transfer exacerbate counterparty risk? To analyze this, we formulate a model which elucidates important differences between financial risk transfer and traditional insurance, using the example of Credit Default Swaps (CDS). We allow for (heterogeneous) insurer insolvency, which captures the possibility that relatively risky counterparties may exist in the market. Further, we find that stable insurers become less stable as the price of the contract decreases. The analysis includes insured parties that have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for trading purposes. We show that traders will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that removes traders can, perversely, cause stable counterparties to become less stable. We conclude with two extensions of the model that consider a Central Counterparty (CCP) arrangement and the consequences of asymmetric information over insurer type.