Economic Capital for Bond Insurers

Abstract

This article presents an approach to computing economic capital and to pricing bond insurance portfolios. Because bond insurers face losses that are highly correlated and dependent on the business cycles, we enhance the Merton structural approach by incorporating business cycles using a Markov switching model. The authors use several risk measures from the insurance literature and explore their impact on calculation of a bond insurer's economic capital. They show how the insurer's characteristics and insured bond portfolio affect its economic capital and analyze the marginal impact of adding a new bond insurance contract to an existing portfolio. Such analysis is useful when setting the premium for a new insurance contract. Overall, the premium will be highly dependent on the measure used to compute capital at risk.