Are Credit Default Swaps Insurance?1
The short answer to the question is, “it depends.” The result of the analysis may also have an impact on who regulates. Central to this debate is whether a Credit Default Swap (CDS) contract is itself insurance and, therefore, should be regulated by the states, or whether a CDS contract is more accurately defined as a security and is not insurance, in which case it should be regulated (if at all) by the federal government.
There are two basic types of CDS contracts. The first is what is called a “covered” contract. At its most basic level, the buyer of the protection owns the bond to be protected and will have a loss in an insolvency event. Certainly, the buyer has an insurable interest which is being protected.
The other type of CDS, and by far the most common, is a “naked” contract. In this type contract the buyer does not own the underlying bond. This contract becomes a vehicle for speculating on a bond issuer’s credit. The buyer of the protection is essentially short on the credit, while the seller is long. Some have called these type contracts a wager and suggested they be outlawed.
In the early stages of the CDS market, the covered swaps were used to transfer and reduce risk of the owner of a bond (the risk that the bond issuer will default.) Covered CDS contracts are a method of protecting an investment. These types of recovery swaps are still in use, although it is estimated that they represent a small minority of the overall CDS market.
Eventually, Wall Street bankers became involved and created markets where the institutional buyers and sellers of swaps did not own the underlying obligation and bought and sold the swaps to place a directional bet on a company’s creditworthiness. These naked default swaps became more valuable as a company became less credit worthy. Instead of hedging risks, these transactions created risk, which some believe are at the core of the current financial crisis.
New York Superintendent Eric Dinallo provides a detailed history of the regulation of credit swaps in his testimony to the House Committee on Agriculture2. Since being authorized as a financial instrument in the year 2000 by amendment of federal law, the credit default market has been entirely unregulated.
No one seriously debates the conclusion that credit swaps should be regulated. But how and by whom?
A ruling in 2000 by the New York Department of Insurance that swaps were not insurance was based upon a factual request describing a “naked” contract, not a “covered” contract. The market ran with the ruling as if it pertained to both.
In late 2008, the New York Department issued a notice that it intended to regulate “covered” contracts, but not “naked” contracts. More recently, Superintendent Dinallo has said he would hold off regulating “covered” contracts as insurance until Congress provided guidance, but that he favored regulating all credit default swaps “holistically”, meaning that a single regulator should regulate the entire CDS market.
There seems little doubt that under New York law a “covered” swap is insurance. However, there are differences of opinion regarding whether a naked default swap constitutes insurance. Proponents of an unregulated approach to naked credit default swaps point to an argument that insurance requires an insurable interest and a pooling of risks. A buyer of a CDS has an insurable interest when it can expect to suffer a loss if the underlying company defaults on its obligations. Pooling is also present where a seller of a swap engages in multiple transactions. While this argument has a basis in the general understanding and definition of insurance, it ignores the fact that there are more ways to suffer loss when a company defaults on its bonds than solely by owning the bonds. For example, credit default swaps are useful to hedge a number of different risks, such as the risk that a key supplier would go bankrupt and would not be able to perform on its contract or by a bank wishing to hedge its risk in granting a line of credit. These uses of a CDS could easily give rise to an insurable interest. These examples broaden the definition of what is a covered swap, and hence, insurance.
Of course, a core principle of insurance is indemnification and the principle that an insured cannot profit from the loss. Since losses for an insured party not owning an underlying bond would be difficult to quantify, the bright line between “covered” swaps, which are treated as insurance, and “naked” swaps, which may be treated as securities, is blurred.
Further, the states have adopted expansive definitions of what constitutes insurance. For example, in New York an 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.” NY Ins. Law § 1101(a)(1). New York Law further defines a “fortuitous event” as “any occurrence or failure to occur, which is, or is assumed by the parties to be, to a substantial extent beyond the control of either party.” NY Ins. Law § 1101(a)(2). This statutory definition is broad enough to encompass traditional covered swaps where the buyer owns the underlying bond as well as more attenuated covered swaps mentioned above.
We agree with Superintendent Dinallo that a single Federal regulator of the credit default swap market makes sense. Even though a persuasive argument can be made that “covered” swaps are insurance, we believe the bifurcated oversight of the swap market, with some regulated by the states as insurance, and some regulated at the federal level as securities, would be chaotic and unmanageable.
Thomas Player is a Senior Partner in the firm’s Insurance and Reinsurance Practice. His areas of expertise include insurance and reinsurance, mergers and acquisitions, complex regulatory issues and dispute resolution. Tom received his bachelor’s degree from Furman University and his law degree from the University of Virginia.
1My appreciation to Tony Roehl of our Atlanta office for his invaluable assistance in the preparation of this article.
2The House Committee on Agriculture has primary jurisdiction over futures markets and has proposed legislation to begin the process to regulate the OTC derivatives market. See H.R. 997, The Derivatives Markets Transparency & Accountability Act of 2009.