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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As near as I can tell, the Insurance Industry is Implicitly Guaranteed by the govt. In other words, if there’s a catastrophe, the govt always steps in with money and aid. At best, private insurance helps lessen the govt bill.

Presumably, CDSs could fall under a similar implicit guarantee if seen as insurance. In fact, one could argue that they already have. See, if something is seen to be a positive to society, the govt will step in during a crisis. The real way to deal with CDSs and CDOs is to keep them in the category of gambling. That way, the govt won’t be allowed to step in. It would be like guaranteeing casinos.

Of course, you need to keep banks and other foundational businesses away from CDSs and CDOs. One solution is called Narrow Banking. The alternative is to implicitly guarantee CDSs and CDOs. Don’t even bother saying that the govt should just say “no”.

Felix, you’re right, CDSs shouldn’t be regulated by insurance commisioners. They should be regulated by something like the Nevada Gaming Commission, because they’re just a fancy form of bets. If they were insurance, 4th parties wouldn’t be able to buy them.

There is no reliably repeatable way to quantify risk of loans, so guaranteeing debt should be handled the same way bets on sporting events are. Odds, I mean premiums, should be established based on how many people are betting, I mean worried, that a borrower will default.

And the CDSs should not be sold by amateurs like AIG, they should be handled by the guys who run casinos.

Posted by KenG | Report as abusive

“A CDS is simply a deal whereby two counterparties promise to pay each other a certain income stream. ”

Huh, yes. And so is an insurance policy.

If you want to make the case that insurance regulators are not set up to regulate CDS — go ahead. But if you’re building your case on the semantics of swap vs insurance, you’re just wasting time.

After all, put options are very much a form of insurance, and no one is saying that they should be regulated as insurance.

PS – nice dig at Larry Summers. But it would be more to the point if you also said that he’s fat.

Posted by G.D | Report as abusive

A technicality: I’m pretty sure Ambac was regulated by Wisconsin, not New York.

Posted by anonymous | Report as abusive

‘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…’

It’s not obvious to me why this is a bad idea. Can you expand upon that?


CDS are not swaps. There is no exchange of value between the parties. CSD are what are known as “barrier options” in the insurance world.


Chris Whalen

Why shouldn’t the hotshots issuing CDSes just be required to collateralize?

After all, you BUY your chips at the casino.

Posted by a.k.a. | Report as abusive

Given the realities of power in the so-called insurance and financial “world” can we think of CDS and other exotics more accurately as either swindle or extortion? The financial powerful have failed and the system is now “impossible”. Read Frederick Soddy, Nobel Prize, 1923.Thanks RDuaneWilling

So if I buy $10 billion of insurance I can’t lose billions if the event doesn’t happen? Good to know.

Posted by Zach | Report as abusive

The whole thing could be addressed with the development of markets in some sort of REFS instrument (Regulator Effectiveness Fail Swaps).

Posted by bdbd | Report as abusive

It is not wise to put too much faith in “financial-derivative regulators”. You will remember that there was a massive failure by the banking regulators including the Fed leading up to this crisis. And let’s not forget the SEC and its failures. Let me offer the following comments:

1. The bank regulators had the authority to examine any aspect of a bank’s activities. They had the authority to figure out what was going on at the banks and to limit it. The regulators did nothing.

2. There are dim bulbs and deadwood at the top of the regulatory agencies and all of it needs to be cleaned out. A Herculean task if there ever was one.

3. We recently saw the regulators “stress-test” the major banks and compute the additional capital that the banks required to weather the economic turmoil. Then some of the largest banks complained vociferously about the additional capital requirements and the regulators backed off. More spineless regulation is not a solution.

Posted by Steve Numero Uno | Report as abusive

I agree with your lack of confidence in the capacity of insurance regulators to handle the CDS markets, and I don’t think other regulators would do much better.

So, if we a large-scale derivatives market that is too complicated to regulate, my policy conclusion would be to shut it down. What’s yours?

Posted by John Quiggin | Report as abusive

I believe the only effective “regulatory-like” solution in our free-market system is a clearinghouse for these types of deals. That would provide transparency and price discovery as well as continuous margining. But there are still key details that would need to be worked out for non-vanilla (including highly structured) transactions. For example, how will the clearinghouse compute the risk and thence the required margin?

Posted by Steve Numero Uno | Report as abusive

Keep in mind what insurance is: diversification. If you can diversify your portfolio, you don’t need to pay someone else to diversify it for you.

The AIG fiasco had nothing to do with selling “insurance”. The banks didn’t need insurance. The CDSs were just a way of boosting leverage beyond the legal limit. There was no economic purpose.

Posted by Max | Report as abusive

The only reasonable regulatory framework would be reserve requirements on the entities assuming the risk.

If CDSs were viewed as traditional insurance, then setting the reserve requirements would be an a impossible task. Unlike, say life insurance, where one can make a pretty fair estimate of how many of your customers will pass away in a given year, it turns out to be quite impossible to put probabilities on so-called black-swan events, which are precisely what people want credit default protection against.

Making matters worse, unlike with life insurance or auto insurance, credit default events are highly correlated. Black swans, we have seen, travel in large flocks.

What’s more, the entities bearing the CDS risk will discover that their CDS obligations tend to pop during times of credit contraction and tightness, just as those entities are themselves under balance sheet stress.

The only reasonable reserve requirement would be that the risk-bearing entity holds some very high percentage of their theoretical maximum CDS liability available in ready reserves at all times. They certainly won’t be able to raise these reserves when their balance sheet is under duress.

The effect of any reasonable reserve requirement would be a dramatic curtailing of CDS activity as since CDS’s would require great pools of capital to sit in low return instruments awaiting their swans. Few would want that. Further, even if such contracts were deemed a good use of capital, proper reserving would lead to only a tiny dollar volume of contracts relative to today.

Any reasonable reserve requirement would therefore eliminate most credit default swaps.

Interestly, mere reasonable risk coverage take us a long way toward what has been advocated by Charlie Munger and George Soros, a world where all CDSs are gone.

http://dealbook.blogs.nytimes.com/2009/0 5/01/munger-of-berkshire-calls-for-ban-o n-credit-swaps/

http://www.dailyfinance.com/2009/06/12/g eorge-soros-wants-to-outlaw-credit-defau lt-swaps/

The fact that allowing CDSs while requiring reasonable risk coverage would dramatically reduce the use of CDSs shows that CDSs only thrive by leaving the risk uncovered. One big way that the economy became so highly levered was that CDSs allowed enormous amounts of risk to appear covered when it was not.

Posted by Dan | Report as abusive

Chris Whalen:

That could be the most idiotic thing I’ve ever heard. Yes, CDS are swaps. A swap is just an agreement between two parties to exchange sets of cash flows for a fixed period of time. The parties in a CDS are just exchanging a set of fixed cash flows (quarterly premiums) for a set of cash flows based on the daily replacement cost of the CDS (the mark-to-market). The idea that CDS involve “no exchange of value between the parties” is beyond ridiculous.

How do you still work in financial services?

Posted by Mark | Report as abusive

CDS are innovative financial products that work only in an up market. They should indeed be regulated to prevent overleveraging and total market collapse.

Posted by william | Report as abusive

If I have a variable rate and want to minimize my exposure, I may engage in any number of trades that hedge that risk. Hedging is insurance; I’m literally paying to insure against a degree of interest rate risk. I could do the same with a number of other kinds of risk. So in a real sense, all these trades are insurance. The use of the word doesn’t turn it into insurance for regulatory purposes.

Posted by jonathan | Report as abusive


I think that Whalen’s point is that many sellers of protection on CDS markets are not actually setting aside the necessary resources to make payment when it is due. (See Dan above on this issue too.) If some firms are making promises that they are not prepared to keep, then Whalen is right.

In fact, a while back Paramax, a hedge fund, sold CDS to UBS and then argued that they had a side agreement that it was always understood that they couldn’t pay more than 3% of the amount protected (which was 6x their assets under management) and that UBS had promised never to mark contract in a way that meant Paramax had to pay, so when the bank actually demanded payment the issue ended up in court.
http://www.ft.com/cms/s/0/f34487e4-47d0- 11dd-93ca-000077b07658.html

Mark, would you agree that in this case, there was no exchange of value between the parties?

Posted by csissoko | Report as abusive


Your current article, abstracted, says “Who the hell can regulate these? Not NY! Maybe we should give the SEC another shot?”. The SEC?!? We have to wait around for a celebrity to make a false statement during an investigation about a financially inconsequental event tangentially involving CDS before we will get action? (SEC). We need to wait for a clear violation of a clear statute because there’s nothing else to our job but law enforcement (SEC). Financial knowledge is useless, and possibly a hindrance, because the time spent acquiring this could have been spent on your law degree (SEC). We are proven to be thouroughly corrupt, institutionally and individuals, but this is understandable given our motivation go get the high-paying wall street “compliance” job after we’ve payed our dues in “public-service” (SEC).

What you are saying more clearly is: NY can’t regulate these and you don’t have the faintest idea who was the remotest hope of doing so with any nontrivial chance of success. Which brings us around to: why do we tolerate these if we can’t regulate them other than a hail-mary pass to the SEC (the SEC! the SEC!!!)?

Now, if you want to distract the issue, you’ll refer to your various previous solid articles about how some CDS attackers are confused or misleading or sometimes even factually correct.
What we readers really want (ok, ok, maybe just me) is an affirmative defence of CDS vs what it has cost society. At this point – I’ve tried to fairly read everything you’ve written on this – my honest guess is that you know you haven’t begun to make one, and you are more motivated by a righteous annoyance at the more careless CDS detractors than you are to make a GOOD positive argument for why we collectively should bother with these for-all-*practical*-purpose-unregulatabl e risks. Please prove me wrong.

I’m annoyed. The CDS debacle has funnelled billions from myself and my children, through the AIG conduit, to Goldman folks who have just been told to expect at the least their second most profitable year and highest bonuses ever. I really, really, want to understand the upside here. Not the upside of this very particular situation, but the hundreds of billions of upside this particular finanical innovation has to offer in order to have made the cost even plausibly worthhile.


Posted by axg | Report as abusive

I’ve been doing swaps since ISDA was in diapers, as well as every other kind of financial surety known to the galaxy. Your premises are all wrong here. A CDS on a portfolio of securities is economically the same thing as financial insurance, with a fee paid in exchange for a guaranty. In fact the way you draft a CDS is by taking the standard ISDA swap form, ignoring everything in it, and stapling to the back a financial guaranty agreement that has “Swap Confirmation” written across the top. I don’t know where you got the idea that it’s just the swap of two cash flows (say, like a fixed-for-floating interest rate swap), but your analysis can’t recover from a fundamental mistake like that. If it were a real swap, there would be a theoretical structure where both parties would be willing to do the swap for nothing. That doesn’t happen with either financial insurance or CDS. You can call it a guaranty, a surety, a back-up letter of credit or a CDS, but they are economically the same thing. A CDS is no more a swap than a back-up letter of credit is a letter.

Here’s another easy way to tell the difference between a real swap and a financial guaranty: If it’s drafted by a junior banker with a B.A. in psychology who happens to be sitting at the swap desk this afternoon, it’s a swap. If it takes a team of economists, senior bankers and four Wall Street law firms several months to draft, it’s not a swap.

In any case, it makes sense to regulate financial sureties, however designated, with some consistency. Unfortunately for our economy, swaps were chosen for credit protection transactions precisely because they were an unregulated form, not because of the substance.

As you correctly point out, the financial insurance companies that got into trouble did so mostly because of unregulated CDS transaction, and not because of their regulated insurance policies. It was decision of the financial institutions themselves to evade regulation that got them into trouble, and their self-inflicted wounds can hardly be blamed on the authorities who lacked the power to regulate. AIG (regulated as a thrift institution) was profitiable in its regulated business, and disastrously unprofitable in its unregulated business. That is true of many, many financial institutions that got caught up in the crisis. You could make an argument based on the recent history of regulated financial institutions and CDS that regulation needs to be consistent, or over-exploitation of a loophole (like CDS) can lead to problems. But that’s an argument for consistency of regulation, not against regulation itself.

Posted by RobNYNY1957 | Report as abusive