Using credit default swaps (CDS) to imply a firm or sovereign default probability is laden with difficulties making the resulting estimate unreliable. This paper exposes these difficulties using a simple analogy to life insurance premiums. An analogy is used because the logic is more easily understood in this context. The difficulties are unraveling the impact of risk premium, counterparty risk, market frictions, and strategic trading. Given a well-understood alternative to implied CDS default probabilities is available, actuarial-based default probabilities, banking regulations, and risk management decisions should not be based on CDS implied default probabilities. Commonly believed that credit default swap (CDS) implied probabilities provide unbiased estimates of a corporation’s or sovereign’s actual default probabilities or credit risk. The purpose of this paper is to show why this common belief is false using an intuitive analogy between CDS and life insurance premiums. For life insurance, the difficulties of using insurance premiums to imply the mortality probability are crystal clear. The difficulties are unraveling the impact of risk premium, counterparty risk, market frictions, and strategic trading. These difficulties are well known in the academic literature (references are provided below). Of course, all is not lost because there is no need to use these implied probabilities. Readily available actuarial-based mortality tables are used to determine mortality probabilities. And insurance premium implied mortality probabilities are not used for risk management nor in regulation.

Due to the Dodd-Frank Wall Street Reform and Consumer Protection Act, credit ratings are no longer going to be included in U.S. financial regulations. Hence, U.S. regulators are searching for an alternative method for accessing default probabilities and credit risk. CDS implied default probabilities are being considered. But as shown above, this is a foolish alternative. The most obvious choice is the analog to actuarial-based mortality probabilities, actuarial-based default probabilities conditioned on the characteristics of the firm under consideration.