Credit Derivatives Are Not ‘Insurance’

The superficial similarity of credit derivatives to typical insurance products, like property or life insurance, has caused some politicians and pundits to argue that credit derivatives are a form of insurance and should be regulated as such. The former director of the Commodities Futures Trading Commission (CFTC), which regulates most derivative products, declared: “A credit default swap . . . is an insurance contract, but [the industry has] been very careful not to call it that because if it were insurance, it would be regulated.” New York State went even further. New York State Insurance Commissioner Eric Dinallo testified before a House Committee investigating credit derivatives: “the insurance regulator for New York is a relevant authority on credit default swaps,” because “[w]e believe . . . [they are] insurance.” Although New York has delayed its regulatory plans pending a federal review of credit derivative regulation, the question of whether credit derivatives are insurance remains an open and much bandied about one that needs to be analyzed.

In a forthcoming paper in the Connecticut Insurance Law Journal (available as a University of Chicago Law & Economics, Olin Working Paper here) I argue that it makes little or no sense to regulate credit derivatives as or like “insurance,” regardless of whether they are used as to reduce risk for one party. The instinct to call credit derivatives “insurance” is sensible enough – the lender buying credit protection looks much like an insured and the party selling credit protection looks much like an insurer, at least where the protection seller is in privity with holders of notes of indebtedness. The analogy is obvious: in a plain-vanilla credit default swap, the bank making an original loan pays a premium to a third party that in turn agrees to make the bank whole in the event of a future liability, that is, a default on the underlying loan or bond. This transaction resembles a typical insurance contract, where the insured pays a premium to a third party (an insurance company) in return for a promise to make the insured whole in the event of a loss.

But observing that something resembles or provides insurance against loss is not enough to warrant regulating it as “insurance.” Many contracts that are not called insurance or regulated as insurance imbed some component of insurance or risk sharing. For instance, when a farmer enters into a contract that allows the farmer to sell wheat at a fixed price in the future – a forward contract called a put option – the farmer is in effect insuring against a drop in the price of wheat. On the other side of this transaction, there may be a baker who enters into a forward contract that allows the baker to insure against an increase in the price of wheat. Both parties are buying price insurance from each other, likely with a middleman, known as a market maker, standing between and reducing the counterparty risk in the transaction. But these contracts, and all similar hedging contracts entered into by regular consumers and sophisticated financial entities, are not regulated as insurance contracts. The point can be made more bluntly: it would be fanciful to argue that every contract in which a party could be said to reducing its risk and another party was willing to take on some of that risk is or should be called insurance. If this were the case, state insurance regulators would be involved in regulating hedge funds, commodities, options, swaps, and countless other contracts entered into by consumers and firms. In fact, every contract assigns, shares, and apportions some sort of risk. No one seriously advocates this scope for insurance regulation. Simply providing some risk sharing is not enough to be regulated by state insurance commissioners.

The reason insurance regulation does not extend to every contract that involves some element of insuring risk has to do with the purpose of insurance regulation, as opposed to other types of regulation. There are broadly two justifications for a special law of insurance: first, the peculiar governance problems associated with insurance firms; and second, worries about unsophisticated consumers being duped by complicated and essential products. My Working Paper shows that neither of these justifications obtains or makes sense for the regulation of credit derivatives.

Governance problems arise because insurance companies have an inverted production cycle and do not generally have concentrated creditors like non-insurance firms. This means that two crucial constraints on the potential misinvestment of resources are missing: the feedback to the firm provided by product and other markets is missing given the fact that the insurance company produces its product (that is, payment of claims) many years after the consumers pay for it; and when things go badly for the insurance company, there is no concentrated interest to keep the firm from adopting an excessively risky strategy (from the perspective of creditors (that is, policy holders).

Insurance law is designed to prevent the risk that insurers competing for policyholders, but unconstrained by normal forces, will charge too little for their products. This happens because of the continuous nature of insurance company inflows and outflows, coupled with a delinkage between the time of pricing a risk and the time of paying out the loss from the risk. In other words, insurance can look a bit like a Ponzi scheme, where new creditors of the firm are paying off the liabilities to old creditors. And, just as in a Ponzi scheme, when things go badly for the firm (that is, when actuarial estimates of liability turn out to be wrong), there is a natural tendency to offer new investors an attractive return to increase cash flows to pay for higher-than-estimated outflows.

The second part of the governance problem – the lack of concentrated creditors – exacerbates this problem, since there is no sophisticated entity with bargaining power that can keep the firm from adopting a shareholder-friendly, go-to-Vegas strategy in the event liability estimates in the first period were erroneous. Without these governance constraints, initial misestimates and mistakes can fester and lead to large losses. My Working Paper shows how the counterparties in credit derivative contracts do not have this continuous investment problem or these governance problems, unless, of course, they are insurance companies, and how insurance regulation would be futile in any event.

Consumer problems arise because the consumers of insurance company products are average individuals without the expertise or sophisticated judgment to assess what they are buying in insurance products. The consumer-centric element of insurance regulation consists of three commonly recited justifications: to make sure insurers don’t charge too much; to regulate the substance and terms of policies; and to regulate service and coverage issues. Unlike the average consumer of insurance, the average participant in credit derivative markets is large, sophisticated, and capable of bearing losses. There is simply no basis for transferring the paternalistic impulses of insurance to this market.