THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 323

CHAPTER 12

Nonbank Financial Institutions

291

The investment policies of these companies are affected by the fact that property
losses are very uncertain. In fact, because property losses are more uncertain than the
death rate in a population, these insurers are less able to predict how much they will
have to pay policyholders than life insurance companies are. Natural disasters such as
the ice storm of 1998 and the Calgary hailstorm of 1991 exposed the property and casualty insurance companies to billions of dollars of losses.1 Therefore, property and casualty insurers hold more liquid assets than life insurers: cash, due and accrued
investment income, money market instruments, and receivables amount to over a third
of their assets, and most of the remainder is held in bonds, debentures, and stocks.
Their largest liability relates to unpaid claims and adjustment expenses, followed by
unearned premiums (premiums representing the unexpired part of policies).
Property and casualty insurance companies will insure against losses from
almost any type of event, including fire, theft, negligence, malpractice, earthquakes, and automobile accidents. If a possible loss being insured is too large for
any one firm, several firms may join together to write a policy in order to share
the risk. Insurance companies may also reduce their risk exposure by obtaining
reinsurance. Reinsurance allocates a portion of the risk to another company in
exchange for a portion of the premium and is particularly important for small
insurance companies. You can think of reinsurance as insurance for the insurance
company. The most famous risk-sharing operation is Lloyd s of London, an association in which different insurance companies can underwrite a fraction of an
insurance policy. Lloyd s of London has claimed that it will insure against any contingency for a price.

Credit
Insurance

In recent years, insurance companies have also entered into the business of supplying credit insurance. There are two ways they have done this.
One way insurance companies can in effect provide
credit insurance is by selling a traded derivative called a credit default swap

(CDS) in which the seller is required to make a payment to the holder of the CDS
if there is a credit event for that instrument such as a bankruptcy or downgrading
of the firm s credit rating. (Credit derivatives are discussed more extensively in
Chapter 14.) Issuing a CDS is thus tantamount to providing insurance on the debt
instrument because, just like insurance, it makes a payment to the holder of the
CDS when there is a negative credit event. Major insurance companies have
entered the CDS market in recent years, sometimes to their great regret (see the
FYI box, The AIG Blowup).

CREDIT DEFAULT SWAPS

Another way of providing credit insurance is to supply
it directly, just as with any insurance policy. However, insurance regulations do
not allow property/casualty insurance companies, life insurance companies, or
insurance companies with multiple lines of business to underwrite credit insurance. Monoline insurance companies, which specialize in credit insurance

MONOLINE INSURANCE

1

For example, the freezing rains of January 1998 triggered about 840 000 insurance claims. As a result,
Canadian P&C insurers paid out over $1.44 billion. Similar disasters in the United States, such as the
Los Angeles earthquake in 1994, Hurricane Katrina, which devasted New Orleans in 2005, Hurricane
Ike, which devastated Galveston in 2008, and the September 11, 2001 destruction of the World Trade
Center, exposed the U.S. property and casualty insurance companies to billions of dollars of losses.