Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2008/8: Continuous Monitoring: Look before You Leap

Snorre Lindset () and Svein-Arne Persson ()
Additional contact information
Snorre Lindset: Trondheim Business School, Postal: HiST, TØH, Jonsvannsveien 82, 7004 TRONDHEIM, Norway
Svein-Arne Persson: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: 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-codes: G13; G23; G33

21 pages, March 12, 2008

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