Summary dissection of a Credit Insurance

What does a credit insurance do?

• Credit insurance insures a business from a non‐payment of a commercial contractual obligation. 
• It not only protects a business from known risks but also provide a hedge against the unknowns - economic as well as political.
• Credit insurance is closely linked with a credit risk of a lessee.

Let take a use-case of a rental lease agreement. The rental lease with credit insurance guarantees cash inflows even in case of rental defaults, thus allowing payment of associated costs such as real estate taxes, periodic maintenance etc which ultimately helps to increase the value of the underlying asset.

Measuring Credit Risk:

As noted earlier, Credit insurance is closely linked with a credit risk. Credit risk is affected by probability of default (known risk) and a transaction risk (unknown risk). Put simply, credit risk can be calculated as:

Expected Loss (%) = (Probability of Default)x (Loss given default)

However, above equation does not work when value of underlying asset/obligation/contract appreciates or depreciates. A good example is during rental lease agreement. So, how do we measure credit risk in such cases? Worry not, an effective approach would be to weigh the lessee's financials. For example, during underwriting a lease tenant, focus on tenants financials for which the Altman Z-score3 can be used which help in predicting a tenant's risk of default. Other approaches include S&P ratings, moody's ratings etc.