Why insurance commissioners should not regulate CDS

By Felix Salmon
July 4, 2009

There’s a meme doing the rounds — I fear it may have been caught by my colleague Rolfe Winkler — that credit default swaps are insurance products, and that therefore they should be regulated by insurance regulators. So before this nonsense spreads any further, it’s worth explaining just why that’s a very bad idea.

First, credit default swaps are not insurance, they’re swaps. A lot of journalists talk about them being “like an insurance contract” when they try to explain what they are, and that’s true, as far as it goes — they do share certain characteristics with insurance. But that doesn’t mean they are insurance. It doesn’t mean that some foolish law should be passed forcing buyers of protection to have an “insurable interest” in some underlying debt instrument, and it certainly doesn’t mean that all CDS should be regulated by some insurance commissioner somewhere.

Many swaps can be thought of as being like an insurance contract, should one be so inclined. For instance, when Larry Summers entered into a massive interest-rate swap while president of Harvard, he essentially locked in a fixed rate on the university’s debt: he was insuring Harvard against the risk that rates would rise. But insurance contracts can’t blow up in the way that the Summers swap did: when rates fell, the university ended up losing a cool $1 billion.

Now let’s say that Harvard had bought credit protection on the state of Massachusetts instead — perhaps Summers, worried about the state running out of money, feared that in an attempt to make up a budget gap, it would start (sensibly) taxing the university’s endowment. Just like with the interest-rate swap, if the spreads on Massachusetts’ CDS had tightened in, then the CDS contract would have cost Harvard a lot of money — protection buyers are just as subject to margin calls as protection sellers are (but as buyers of insurance products are not). It’s the same reason why airlines take large one-off gains and losses from their jet-fuel hedges, even if the purpose of putting on those hedges is to smooth out their fuel expenses.

It’s also worth noting that Harvard might well not be considered to have an “insurable interest”, if it didn’t hold any Massachusetts bonds — even though buying credit protection on Massachusetts might make sense. Defaults have repercussions far beyond the narrow circle of bondholders, and there are many people who might want to hedge against a certain entity defaulting, even if they don’t directly hold that entity’s debt.

A CDS is simply a deal whereby two counterparties promise to pay each other a certain income stream. The buyer of protection commits to paying a fixed amount of money every six months; the seller of protection commits to paying an uncertain amount of money (to be determined via an auction mechanism) should certain events happen in the future. Yes, insurance policies work in a similar manner. But so do, say, office lottery pools — a bunch of co-workers all commit to paying a small amount every week on the understanding that if something improbable happens in the future, they will share a large but unknown amount of money.

Even if some bright spark determines that CDS are insurance contracts, however, that doesn’t mean that they should properly be regulated by insurance commissioners. After all, even if they are insurance contracts they’re also financial derivatives, and it’s pretty clear that financial-derivative regulators are much more likely to be able to effectively regulate financial derivatives than insurance regulators are. What’s more, the SEC looks as though it’s going to be given explicit responsibility for regulating CDS; as we’ve seen in the banking sector, all hell tends to break loose when multiple regulators share responsibility for regulating the same companies or financial instruments.

To make matters worse, there is no national insurance regulator in the US: insurance is regulated on a state-by-state level. Why should a credit default swap entered into between two Delaware counterparties be regulated by the New York State insurance commissioner? It makes no sense at all

And let’s not forget that the New York State insurance commissioner — the only insurance regulator even remotely capable of regulating credit default swaps — was the regulator responsible for regulating MBIA, Ambac, and all the other monoline insurers who blew up as a result of writing far too many underpriced credit-default swaps. The SEC may or may not be an effective CDS regulator, but New York State has proved itself an ineffective CDS regulator.

In any event, if you want strong and effective regulation, the last person you want to turn to is an insurance commissioner. Insurance companies are the most highly-leveraged financial institutions in the world, if you look at the ratio of their contingent liabilities to their book value. That’s one reason why most insurers end up blowing up: they’re generally massively exposed to tail risk. Consider life insurers, for instance: they dodged one bullet, when AIDS ended up disproportionately hitting the kind of people (gay men, intravenous drug users) who don’t tend to have children and therefore normally don’t have much in the way of life insurance. But if a pandemic does start scything down a lot of rich people with children, expect a lot of life insurers to go bust — just as property insurers would disappear en masse if a hurricane were to hit Miami or New York. In theory, insurers hedge their catastrophe risk in the reinsurance market; in practice, they don’t, or not completely. And reinsurers can go bust, too.

What’s more, insurance companies are pretty much the last outpost of extreme opacity when it comes to the effects of the financial crisis. Most of the time, the way that insurers work is that they pay out in claims slightly more than they bring in, in terms of insurance premiums; their profit comes from investing those premiums before they’re paid out. If the investment returns are negative rather than positive, as they almost certainly were last year, then the total losses can be enormous. And I’ve been hearing rumors for months that there are lots of insurance companies which are failing to come clean on their investment losses, especially with respect to their securities-lending operations. AIG was not the only firm investing repo proceeds in subprime-backed securities and losing a fortune in the process — who were the others?

One of the reasons I’m still very bearish on the markets and the broader economy is because I’m convinced that there are lots of enormous financial institutions which haven’t even started to come to terms with their losses yet. Some of those institutions are European and other non-US banks; others are large insurers and reinsurers. I have no faith in the insurers’ regulators’ ability to reassure me that such losses don’t exist or are manageable. And I certainly have no faith in their ability to regulate the CDS market. So let’s not go there.

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