The possibility that either one of the parties to a contract will not be
able to satisfy its financial obligation under that contract. The classic example
is that of one commercial enterprise extending credit to another enterprise
or individual. Many insurance arrangements, especially finite risk programs,
also involve varying degrees of credit risk—on both sides of the transaction—depending
on the financial stability of the parties. Since insurance and reinsurance companies
are leveraged (i.e., their capital supports many times its value in outstanding
policy limits), an unforeseen number of severe losses could impair such capital.
While it is generally assumed that credit risk is borne by the insured or ceding
insurer (under a reinsurance contract), insurance and reinsurance companies
also bear credit risk.