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.

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  1. Michael
    Posted Monday, October 19, 2009 at 9:11 am | Permalink

    “the average participant in credit derivative markets is large, sophisticated, and capable of bearing losses.”

    The $175 billion in taxpayer dollars used to bail out AIG would suggest otherwise. I contend that a principal reason for regulating insurance companies is to increase the market’s confidence that insurers are financially strong enough to cover insured losses. As you note, this is necessary because it would be impractical for consumers to have to do a financial analysis of each insurer (or bank for that matter) to independently determine its creditworthiness.

    However, large banks have proven themselves no less susceptible to the assumption that their insurance company (e.g, AIG, Lehman Brothers) will be able to pay out any claims. Many large banks and large investment brokerages lost significant amounts as a result of AIG or Lehman’s inability to cover swap payments (in AIG’s case, without the assistance of bailout funds). Many of these banks would have been weakened beyond survival as a result of these losses combined with their loan defaults if it hadn’t been for bailout funds given directly to the bank or funneled through AIG to support the payment on AIG’s policies.

    Perhaps a simple regulatory scheme that tracks the amount at risk for a certain position (net amount of calls and puts on a given position) and the amount in reserve to pay such claims would benefit the entire economic system by establishing greater confidence in insurance companies.

  2. Warren Murdoch
    Posted Tuesday, October 20, 2009 at 2:39 pm | Permalink

    Don’t consumers of insurance product also have to show that they were harmed before they can collect? In a credit derivative product, the requirement to prove harm is absent.

  3. Marc
    Posted Tuesday, October 27, 2009 at 9:22 pm | Permalink

    My understanding is that the firms which sold credit derivatives operated with an inverted production cycle, taking in “premiums” and making payments, if necessary at some point after those “premiums” were paid.

    The governance problem appears to present itself with credit swap derivatives, in that the issuers of swaps were not only going to the casino for instant returns, but were part of the essential infrastructure which supported the casino, and given free reign of the whole joint in 1999.

    It is one thing to hedge against natural phenomenon, the rain or the price of flour which is based on weather amongst other things. But it is quite another to offer up financial protection to other financial institutions and other private and public entities, while seeking protection from other financial institutions, on creditworthiness, the product of human beings, when the slightest ripple in that web of mutual protection brings the system down.

    Insurance law is supposed to provide some degree of certainty to people and businesses as a hedge against casualty and are regulated to the extent that it would take a massive natural disaster, an event external to the workings of the economic system, to trigger a systemic failure of the regulated insurance sector. Even a large spate of burglaries, deaths, pandemic, fires and such can be eaten without distress.

    Contrast that with credit derivatives, which are incestuous enough so as to provide a false sense of certainty, as has played out so dramatically. When these derivatives are based on the economic fundamentalist belief that asset prices will always rise, then you get what you always get when you mix religion and money.

    As a layperson, perhaps it would make sense to adopt for credit derivatives aspects of insurance law, if any, which keeps the web of risk contained with bulkheads so that failure can be contained. Of course, there were bulkheads in place in the form of Glass Steagall, which were abrogated by Gramm Leach Bliley.

    Finally, it appears that only those who assembled these credit swap derivatives were able to know exactly just what they meant. Some of the almost smartest minds on Wall Street and in the regulator community saw these products created by the smartest minds as opaque as a CDO.

    To paraphrase your own words on why insurance is regulated like insurance:

    “Consumer problems arise because the consumers of credit derivative company products are businesses, public sector entities, professional investors, and Wall Street players without the expertise or sophisticated judgment to assess what they are buying in credit derivative products.”

    The average participant in the derivative swap market is the universe of government and corporations, given that if these products provide a false sense of certainty, then we are all participants on the receiving end of unsustainable transactions in a grossly unregulated market.

  4. Julia
    Posted Sunday, December 20, 2009 at 9:50 pm | Permalink

    How about regulating “naked” credit default swaps like insurance? These are bets against the default of a company when the buyer has no financial stake in the company in the first place. In other words, it is not a hedge, but a pure speculation.

    Since naked CDS buyers only gain when the company goes under, they have every interest in contributing to the collapse of the company (such as spreading rumors in the market). The negative impact of naked CDS on companies and financial markets is similar to naked short selling. While naked short selling has finally been outlawed – after years of resistance from the Wall Street, naked CDS is still legal.

    If one is not allowed to buy insurance against another’s death under insurance law, then that is a useful reference for regulating naked CDS.

  5. Doug
    Posted Monday, March 15, 2010 at 2:19 am | Permalink

    An opinion:

    To quote Mr. Henderson’s conclusion: “Unlike the average consumer of insurance, the average participant in credit derivative markets is LARGE, SOPHISTICATED, and CAPABLE OF BEARING LOSSES. [Therefore] There is simply no basis for transferring the paternalistic impulses of insurance to this market.”

    [Caps are my emphasis.]

    What planet does Mr. Henderson live on?

    LARGE ? True, the average Credit Default Swap (CDS) participant certainly is large; in fact, very many are so large they CANNOT BE ALLOWED TO FAIL. If they COULD bear losses, as Mr. Henderson claims, then why the bailouts? Given the impact of the ginormous bailouts we’ve seen, and the great repercussions they have created elsewhere – except in the offices of the CDS-people, of course – this criterion alone is a major reason to regulate.

    SOPHISTICATED ? Many sources (e.g., “Too Big to Fail,” “The Big Short,” “Free Fall”) demonstrate that these CDS (and related derivative) guys – literally, multiple skyscraper floors full of 1000’s of panicked weekend-working MBAS and lawyers from firms and government agencies – had no clue. From the time of Bear Stearns’ collapse and buyout, then to the runup to the collapse of Lehman Brothers, to say nothing of the aftermath, they had no clue, and could not care less, as to what they were doing to the nation’s mortgagees as well as to the world in the long run. Their main concern was that they somehow convince (fool?) enough investors, as well as the public, so their firms (and their jobs) could “just make it to Monday!”

    CAPABLE OF BEARING LOSSES ? Not the way these guys mitigated their (and our) risks. Again, if they COULD bear these losses, then why the bailouts ? The extreme scale of the bailouts proves how INcapable of bearing losses Credit-Swapping folks really were. Only now, after their bailouts, they are whole, complete with their bonuses, and we (Mr. Henderson’s “average [unknowing] consumers of [CDS] insurance”) are not.

    All my friend bought was a straightforward mortgage. Nobody told him about selling it and converting it – along with many others – into one or more Credit Default Swaps.

    But now, predictably, due to the actions of the herd of CDS guys, his house and many many others are now “under water.” It was only a question of WHEN, not IF, the “water level” would rise. What’s wrong with this picture? How ’bout “no regulation ?”

    It is said (by the givers and receivers of bonuses alike) that bonuses are needed to retain rare talent. Given the level and kind of talent the bonus-receivers – and givers – have so flagrantly displayed, it would seem fairer that they should be let go ASAP to join the rest of us in the unemployment lines that they, acting so unsophisticatedly in concert, created.

    It seems that when you consider the reality of the three criteria that Mr. Henderson presents, he actually makes a really good case FOR radically enhanced regulation, regardless of whether you call these CDS guys’ activities “insurance,” “playing in their sandpiles,” “fooling Mr. Henderson,” or whatever.

    Who’s Esq. Henderson trying to fool? Apparently, the Harvard Law School Forum on Corporate Governance and Regulation. And maybe his colleagues at the Chicago Law School as well. One wonders who he billed for writing this post.

    In any case, it definitely appears that he has succeeded, at least with an n of 1: himself.


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