Monday, July 6, 2009

CDS Are Not Insurance Contracts

Felix Salmon is right: CDS should not be regulated by insurance commissioners, primarily because CDS are not insurance contracts. Felix does a good job of explaining why CDS shouldn't be regulated by insurance commissioners, so I won't repeat him. I can, however, provide the legal reasoning. Virtually all US-based CDS are governed by New York state law. Section 1101(a)(1) of the New York Insurance Law defines an "insurance contract" as follows:

"Insurance contract" means any agreement or other transaction whereby one party, the "insurer," is obligated to confer benefit of pecuniary value upon another party, the "insured" or "beneficiary," dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event.
First, protection sellers in CDS contracts are obligated to confer a benefit of pecuniary value on protection buyers dependent upon the happening of a defined credit event (e.g., bankruptcy, failure to pay). Second, a credit event in a CDS contract probably qualifies as a "fortuitous event." However, a CDS contract does not require that the protection buyer have a "material interest which will be adversely affected" by a credit event—as everyone knows by now, CDS contracts don't require the protection buyer to own the reference obligation, or to have any interest whatsoever in the reference entity. Moreover, payment by the protection seller in a CDS contract is not dependent on the protection buyer suffering an actual loss, whereas actual loss is a fundamental element of an insurance contract. In 2000, the NY Insurance Department's Office of General Counsel issued an opinion concluding that CDS do not constitute insurance contracts. The opinion doesn't appear to be available on the internet, so I've embedded it below. Here's the key language in the 2000 OGC Opinion:
[A] credit default swap . . . does not meet the definition of Insurance contract in N.Y. Ins. Law Section 1101(a)(1)(McKinney 1985)1 because, under the terms of the transaction, the seller will make payment to the buyer upon the happening of a negative credit event and such payment is not dependent on the buyer having suffered a loss.
In other words, as long as CDS contracts don't require protection buyers to suffer an actual loss in order to collect payment, they don't constitute insurance contracts under New York law. (I'm ignoring the NY Insurance Department's ridiculous attempt last September to reinterpret the definition of "insurance contract" to include covered CDS, because the Department subsequently dropped the ill-considered plan, and its legal reasoning was, to be perfectly honest, a joke. It was a purely political stunt.) 2000 OGC Opinion


Anonymous said...

No CDS are obviously gaming contracts.

Anonymous said...

Okay, so CDS aren't insurance contracts because they don't require a material interest. But a question that is commonly asked is whether it should be allowed to buy that kind of financial protection on assetts you don't have a meterial interst in.

I guess it just seems to me that you didn't answer (and didn't intend to answer) a much more interesting question: Should CDS be made to fit the definition of insurance, and then be regulated as such?


Ken Houghton said...

Why should one need to have an exposure to buy insurance? One can buy, e.g., a Put Option on MSFT without owning the stock.

You could even sell a Call option on MSFT without owning the stock.

Or, if you own MSFT, you can sell AAPL Puts as a hedge. (Which you might do if the market is more liquid in the latter than the former. Or if a company are less visible than those above, but in the same field.)

A hedge is a hedge, speculation is speculation, but it's virtually impossible to tell one from the other in making market restrictions. (That's what the tax code is for.)

Anonymous said...

Equity put options have an observable, tradeable underlying instrument (the stock).

CDS have no such thing. And please anyone that says corporate bonds are the underlying instrument for a CDS should first read about Boaz Weinstein or John Thain.

CDS are gaming/gambling contracts like betting on the over/under in a football game.

Anonymous said...

Quoted from above comment:
"I guess it just seems to me that you didn't answer (and didn't intend to answer) a much more interesting question: Should CDS be made to fit the definition of insurance, and then be regulated as such?"

That pretty much sums up this blog. A series of narrow, technically correct arguments that completely ignore the larger, more important questions. You have to watch this blog over a period of time to really get an appreciation for how this is a deliberate strategy. Selective presentation of truth is a form of propaganda. On whose behalf is it being offered? We don't know because the author is anonymous but I would be interested to find out just how much money this blogger's law firm makes representing the institutions that currently profit from an unregulated CDS market.

Ebophelia said...

There is very important fallacy in that argument that it "does not require" the material loss.

We have two kinds of CDS, those who are based on material loss and those who are not. And what does the law say about the first group?


The fact, that there are CDS that are not insurance contracts does not mean that no CDS are insurance. This is no brainer, simple logic.

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