A credit default swap (CDS) is similar to a traditional insurance policy, inasmuch as it obliges the seller of the CDS to compensate

the buyer in the event of loan default. Generally, this involves an exchange or "swap" of the defaulted loan instrument (and with it the right to recover the default loan at some later time) for immediate money - usually the face value of the loan. However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct "insurable interest" in the loan. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $38.6 trillion by the end of 2008. Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. CDSs have many variations.
[2] [1]

In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index

CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.
[3]

CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose asystematic risk to the economy.
[2][5][6] [4]

In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data)
[7]

announced it would voluntarily give regulators greater access to its credit default swaps database.

Not insurance
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example: The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.
[13][14][15][16]

In contrast, to

purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt obligation;

the seller doesn't have to be a regulated entity; the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;

insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;

in the United States CDS contracts are generally subject to mark-to-market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;

Hedge accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.

However the most important difference between CDS and insurance is simply that an insurance contract provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial analysis. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same 'Reference Entity' the CDS contract refers to. Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of CDS the protection buyer may need to unwind the contract, which might result in a profit or loss situation Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims.

Risk
When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk: The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultaneously ("double default"), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost. The seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party that is, it hedges its exposure. If the original buyer drops out, the
[2][3]

seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller. In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/clearing house, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the counterparty will be held with the central exchange/clearing house. As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require to pay an upfront at the beginning (also referred to as "initial margin").
[17]

Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk.

[2]

A seller of a

CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers.
[18] [2][18]

This risk is not present in other over-the-counter derivatives.