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