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Translation of Risk into Credit Risk: Overview of Simple Financial Positions
Introduction:
In a previous note, it was highlighted that one of the functions of financial law is to translate many kinds of risk into credit risk. It was also highlighted that this translation is achieved through financial positions, and a simple financial position was cited as an example.
In this note, we will discuss the meaning and characteristics of simple financial positions, as well as highlight the various types of such positions.
Meaning of Simple Financial Positions (or Unfunded Credit Protection):
Like other financial positions, simple financial positions are in the form of contracts between protection buyers and risk takers.
At its core, simple financial positions, such as an insurance contract, transfer risk from the protection buyer to the risk taker, but do not contain provisions or built-in mechanisms that protect the protection buyer if the risk taker fails to perform its obligations.
In characterising what amounts to a simple financial position, Joanna Benjamin, in Financial Law, at page 49, stated:
One party to such contracts acts as risk taker or protection provider. Typically it does so in exchange for a fee or other return, such as an insurance premium, although individual guarantors often act gratuitously.
The protection provider agrees to take a specified risk from another person, known as the protection buyer or, where a third party pays for the arrangement as under a standby credit or performance bond, the beneficiary.
The protection buyer or beneficiary is thus protected from the specified risk, but in its place bears the credit risk of the protection provider.
To illustrate, consider an insurance contract between Legum Ltd. and XYZ Insurance Company. Under the contract, Legum Ltd. insures its factory against loss by fire with XYZ Insurance Company. This insurance has the following effect:
What the learned author means by the statement that “the protection buyer or beneficiary is thus protected from the specified risk, but in its place bears the credit risk of the protection provider” is that, although Legum Ltd. is now protected from loss by fire, there is a new risk that XYZ Insurance Company will not fulfil its obligations to compensate Legum Company Ltd. if there is actually a loss by fire. This new risk is known as a credit risk, and it is borne by Legum Ltd. Accordingly, while the original risk of loss by fire is transferred to XYZ Insurance Company, a new credit risk arises: the risk that XYZ Insurance Company may fail to perform its obligation under the insurance contract.
Types of Simple Financial Positions:
The following are the types of simple financial positions:
These are discussed extensively in subsequent notes.