CDS issuers could skip capital reserves by assuming the insured entity never defaults.

Evidence

A CDS is basically an insurance policy you can sell on. It insures the purchaser of the CDS against the default of the bond upon which it is written. In return, the issuer of the CDS, the writer of the insurance policy, receives a regular income stream from the purchaser, just as an insurance company receives customers’ insurance premiums. The difference is that insurance companies typically rely on such measures as actuarial tables to calculate the risks they are covering, and then work out how much cash they need to have on hand to cover people cashing in their policies, as they surely will. They also build up cash reserves to pay out on the policy claims that will inevitably be made against the firm. But if the probability of default of a given entity (Lehman Brothers, for example) is considered to be extremely unlikely, and if you write a CDS contract on that entity, you won’t think you have to keep very much capital at all in reserve to cover anticipated losses because no such losses are anticipated. — Mark Blyth, Austerity, 92

Categorization

• DEFINE: Definition of credit default swap contrasted precisely with regulated insurance underwriting practice.
• XREF: The unregulated capital-reserve gap in CDS underwriting is the institutional detail that connects financial fragility to the choice for austerity over stimulus.