Continuous Monitoring: Look Before You Leap
22 Pages Posted: 21 May 2008
Date Written: March 12, 2008
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, the 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. We argue that the ability to continuously monitor the equity value of a company can be a new explanation for why jump processes may be important in models of credit risk.
Keywords: credit risk for non-life insurers, guarantee fund, continuous monitoring, barrier options
JEL Classification: G13, G23, G33
Suggested Citation: Suggested Citation