Systemic Risk, Financial Crisis, and Credit Risk Insurance

• DOI: http://doi.org/10.1111/fire.12009
• Author: Fang Chen,Xuanjuan Chen,Zhenzhen Sun,Ming Zhong,Tong Yu
• Date: 01 August 2013
• Published date: 01 August 2013

The Financial Review 48 (2013) 417–442

Systemic Risk, Financial Crisis, and Credit

Risk Insurance

Fang Chen

University of New Haven

Xuanjuan Chen∗

Shanghai University of Finance and Economics

Zhenzhen Sun

Siena College

Tong Yu

University of Rhode Island

Ming Zhong

Shanghai University of Finance and Economics

Abstract

Differing from conventional insurance firms whose underwriting business does not con-

tribute to systemic risk, credit risk insurance companies providing credit protections for debt

obligations are exposed to systemic risk. We show that credit risk insurers (CRIs) underper-

formed conventional insurance companies during the 2007–2009 financial crisis, and such

underperformance is attributed to the greater systemic risk of CRIs. Wealso find that the credit

∗Corresponding author: School of Finance, Shanghai University of Finance and Economics, 100

WuDong Road, Shanghai, China 200433; Phone: (8621)65904556; Fax: (8621) 65103925; E-mail:

chen.xuanjuan@mail.shufe.edu.cn.

We thank Andre Liebenberg, Robert Van Ness (the editor), two anonymous referees, and the participants

of the 2010 World Risk and Insurance Economics Congress Meetings and the 2011 FMA meetings for

helpful insights and comments. All errors are our own.

C2013, The Eastern Finance Association 417

418 F.Chen et al./ The FinancialReview 48 (2013) 417–442

spreads of insured bonds increase significantly after their insurers are downgraded or put in

the negative watch list. We control for alternative factors affecting bond credit spreads and the

result is robust.

Keywords: s ystemicrisk, credit risk insurers, financial crisis

JEL Classifications: G01, G12, G22

1. Introduction

Considered an event occurring “once-in-a-century” (Greenspan, 2009), the

2007–2009 financial crisis caused unprecedented losses to the financial market. Trig-

gered by the collapse of the U.S. housing market, the financial crisis developed into a

systemic event resulting in wide spread defaults of the real economy and large drops

in security markets around the world. While the limelight was on titanic losses in

the mortgage markets and the banking sector, few would disagree on the significant

role played by the American International Group (AIG) in the crisis due to its in-

volvement and losses from the credit default swaps (CDS) business. In addition to

AIG, financial guaranty insurers (FGIs) that insure mortgage/asset backed securities

were badly hit by the crisis. Yet, none of the extant studies have thoroughly exam-

ined the role of insurance firms that provide credit risk protection in the financial

crisis.1

We first examine how credit risk insurers (CRIs) are affected by their exposure

to systemic risk during the 2007–2009 financial crisis. CRIs are firms that provide

financial guaranty and write CDS. Based on the Geneva Association (2010), FGIs

covered 2.3 trillion USD of financial assets in 2007. The notional value of CDS

contracts written by multiline and monoline insurers is also substantial: at the end

of 2006, the notional value of CDS written by insurers was around 1.4 trillion USD

(Geneva Association, 2010). A common feature of FGIs and insurers writing CDS

is that they potentially have a strong link with the financial system, and the loss of

securities under protection would be transmitted to the loss of associated insurers very

quickly.

We document that CRIs experience much worse stock and operating perfor-

mance than other insurers in the crisis. Note that systemic risk is considered the

collapse of the market due to a breakdown in the financial system. We attribute the

1Acharya, Biggs, Richardson and Ryan (2010) investigatethe role of the financial regulations on mitigating

systemic risk in the insurance sector.Billio, Getmansky, Lo and Pelizzon (2010) examine the measurement

of the systemic risk among the finance and insurance sector due to its interconnectedness. Cummins and

Weiss (2011) and Grace (2010) examine systemic risk for all property and life insurers while Harrington

(2009) focuses solely on AIG. None of the extant works study the experience of credit risk insurance

sector during the crisis.