Credit derivatives and insurance October 27, 2009 at 6:27 am

The standard argument that credit derivatives are not insurance runs in brief:

  • They require no insurable interest;

  • They require no proof of loss; and in particular
  • The payout is independent of the counterparty

All of this is standard, and goes back to an opinion of Robin Potts. Now, with ill-advised US action to regulate some credit derivatives activity as if it were insurance deferred, there is a new and more comprehensive account of the issues from M. Todd Henderson.

Henderson does a reasonable job, although the case seems a little over-argued to me. In particular, credit derivatives product companies (CDPCs) are much like insurers in financial substance – as was the Financial Products Group of AIG. So arguing from the perspective of the need to regulate insurers not applying to companies engaging in CDS may involve ground that is not firm. Where Henderson is good, though, is pointing out where risk shifting and pooling contracts in other spheres do not constitute insurance. For instance, if I set up a company to sell naked puts to commodities producers, and invest the premium, then I am acting as a pooling and risk shifting enterprise, but not an insurance company. The paper is worth a read if you have an interest in these matters even if it does seem to me a little propagandist.

Update. It is worth pointing out that the ‘insurance’ vs. ‘not insurance’ question is about more than regulation. It also affects accounting – insurers have their own accounting framework which is rather like accrual – and taxation. Given that much of the need to regulate CDS relates to counterparty credit risk, it seems that a much more cost effective fix to the vulnerabilities revealed by AIG is simply to do what we are doing anyway – set up a central clearing and market data reporting entity. Add in a reclassification of financial insurance as a derivative, enforce fair value requirements, and prudent capital requirements, and you would have a reasonably robust regulatory framework without the need to get insurance regulators involved.

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