Over the past three months, the National Conference of Insurance Legislators (NCOIL) Task Force on Credit Default Swaps Regulation (Task Force) has drafted model legislation which would regulate credit default swaps as insurance.1 If enacted by the states, this NCOIL model legislation (Model Legislation) would ban so-called "naked" credit default swaps, which currently account for as much as 80 percent of the existing credit default swap (CDS) market,2 and would dramatically change the way in which credit default products are regulated and offered in the United States. The Task Force is scheduled to present the Model Legislation for NCOIL's approval at NCOIL's upcoming July 9-12 meeting in Philadelphia.
This client alert describes the Model Legislation and the backdrop against which it was developed, and discusses the implications of the Model Legislation for the capital markets.
What is a Credit Default Swap?
A credit default swap is a contract in which one party, the protection buyer, makes a series of payments to the other party, the protection seller, and, in exchange, receives a payoff from the protection seller if a specified credit event occurs with respect to one or more debt obligations referenced in the CDS. In the typical CDS, the amount of the payoff is measured by the decrease in market value of the referenced obligation upon the occurrence of the credit event, without regard to whether a holder of that referenced obligation would actually suffer a loss. Credit events typically include failure to make a payment, bankruptcy, and, in some cases, restructuring of the referenced debt obligation. Virtually all credit default swaps are documented using standardized contracts published by the International Swaps and Derivatives Association, Inc. (ISDA).
Some market participants have characterized credit default swaps as either "covered" or "naked." A "covered" CDS is purported to refer to a transaction in which the protection buyer owns, or has an economic exposure to, the underlying debt instrument. Virtually all credit default swaps provide, however, that the parties to the swap need not own the referenced obligations. Accordingly, even in so-called covered swaps, the parties may or may not own the referenced obligations for the duration of the swap. A "naked" CDS, in contrast, is purported to refer to a transaction where the protection buyer does not own or have economic exposure to the underlying instrument.
Credit default swaps are often used to manage the swings in market value which may arise from defaults in a debt portfolio. A holder of a corporate bond, for example, may hedge its exposure by buying protection in a CDS with respect to that bond. If the bond goes into default, the proceeds from the CDS generally will cancel out the resulting decrease in market value of the underlying bond. Note, however, that if the bond subsequently recovers its value, as might be the case for a senior secured bond which ultimately is paid in full in a bankruptcy, for example, then the CDS protection buyer will have received a payment for which it never suffered a corresponding loss.
Are Credit Default Swaps Insurance?
The New York State Insurance Department (NYSID) issued an opinion in 2000 stating that a credit default swap is not insurance because the protection seller's payment is triggered "upon the happening of a negative credit event and such payment is not dependent upon the buyer having suffered a loss."3 The NYSID had previously issued several opinion letters confirming that other types of derivatives—catastrophe options, index swaps, and weather derivatives—were not insurance, because the payments under those derivatives were not dependent upon a party suffering a loss.4
On September 22, 2008, the NYSID proposed in Circular Letter No. 19 to treat credit default swaps as insurance when purchased by a party who "holds, or reasonably expects to hold, a material interest in the referenced obligation."5 On November 20, 2008, however, the NYSID issued a First Supplement to Circular Letter No. 19, in which it stated, "In light of [the] progress made toward comprehensive federal regulation of credit default swaps, New York will delay indefinitely its application of New York Insurance Law to credit default swaps."6
Following the NYSID's lead, the New York State Legislature recently introduced a bill to remove all CDS references from Article 69, effective August 1, 2009.7 This action also appears to have been premised on continued progress on federal regulation of credit default swaps.8
NCOIL's view, consistent with that of Superintendent Dinallo, is that credit default swaps—more specifically, "covered" credit default swaps—are insurance. Task Force Chair Assemblyman Joseph Morelle stated in testimony before Congress that NCOIL was developing the Model Legislation based on its view that credit default swaps are a species of insurance, that the states are best suited to regulate this type of financial guaranty, and that so-called "naked" credit default swaps are more akin to gaming than insurance because they lack an insurable interest.9
Some in the insurance community do not agree that credit default swaps are insurance, however. At a January 2009 NCOIL hearing on the regulation of credit default swaps, the National Association of Mutual Insurance Companies submitted comments which included the following:
Credit default swaps … are not insurance products under established law and are neither managed nor regulated as insurance. … [Credit default swaps do not distribute risk] according to hazard, experience, and the laws of averages. … The vast majority of credit default swaps clearly lack insurable interest and are initiated by speculators who have no exposure to the underlying debt instrument whose credit default risk a credit default swap could be used to hedge. Unlike in insurance, there is no necessary relationship between the amount of CDS "protection" sold and the size of the issued debt potentially being protected. This not only conflicts with the basic rules, but also the core function of insurance: credit default swaps can be a source of additional risk whereas insurance can only serve to reduce risk. …
In addition to the lack of insurable interest present in the vast majority of credit default swaps, the basic relationship between insurers and insureds compared to that between seller and buyer in any CDS transaction is fundamentally and qualitatively different. … By creating classes of insureds that correspond to individual risk profiles, the insurance market is able to efficiently spread catastrophic risk across the full spectrum of policyholders. In contrast, derivatives reduce risk through trading—matching counterparties with complementary and offsetting risk profiles.10
Capital markets and derivatives trade groups also have stated that credit default swaps are not insurance. In a joint letter to the Task Force, dated May 22, 2009 (the SIFMA/ISDA Letter), the Securities Industry and Financial Markets Association (SIFMA) and the International Swaps and Derivatives Association (ISDA) stated that credit default swaps are not insurance and pointed out several characteristics that distinguish the two transactions. First, whereas insurance requires an insurable interest, credit default swaps are often purchased by protection buyers that are not hedging a specific underlying risk. Second, CDS contracts are often bought and sold, as opposed to insurance contracts, which are typically held by the buyer. Finally, the typical credit default swap provides for a payment upon the occurrence of a credit event, without regard to whether a holder of the referenced obligation ultimately would suffer a loss, whereas insurance contracts only pay out when the insured party incurs a loss.
The Model Legislation
The text of the Model Legislation is based closely on New York's financial guaranty insurance law (Article 69). The Model Legislation adopts most provisions of Article 69 outright, replacing the term "financial guaranty insurance" with "credit default insurance."
The Model Legislation broadly defines the term credit default insurance (CDI) to cover all extant forms of credit default swaps, including both so-called "covered" and "naked" credit default swaps. The Model Legislation then specifies that CDI may be issued only to a party that "has, or is expected to have at the time of the default … a material interest" in the debt obligations to be insured;11 all other CDI would be illegal and subject to civil and/or criminal penalties.12 The effect of these provisions would be to ban naked credit default swaps.
Under the Model Legislation, only an entity qualifying as a credit default insurance corporation would be permitted to issue credit default insurance, i.e., "sell protection" under a CDS.13 The Model Legislation specifies financial requirements for credit default insurance corporations, subjecting them to capital adequacy requirements more stringent than those applicable to financial guaranty insurers under New York's Article 69. A credit default insurance corporation must maintain a "minimum surplus to policyholders" of at least $150 million, for example.14 A credit default insurance corporation must also maintain contingency, loss, and unearned premium reserves similar to those required under Article 69.15
A credit default insurance corporation would be subject to regulation as a property/casualty insurer to the extent not inconsistent with the Model Legislation.16
Open Questions on Model Legislation
- Material Interest. As noted above, credit default insurance is authorized under the Model Legislation only if the insured "has, or is expected to have at the time of the default … a material interest" in the debt obligations to be insured. The Model Legislation does not define "material interest" or provide a mechanism for an insurer to determine whether a party has or is expected to have a material interest in the insured obligations. It is not clear how an insurer would confirm that the insured party has such an interest. In addition, the Model Legislation does not address what happens if the insured disposes of its interest in the debt obligations after the insurance is issued, theoretically converting the credit default insurance from covered and legal to naked and illegal.
- Jurisdictional Reach. Another unanswered question in the Model Legislation involves the scope of the jurisdiction granted to a state that adopts the Model Legislation. The Model Legislation provides that credit default insurance may be "transacted in this state" only by a corporation licensed for such purpose, but does not define the phrase "transacted in this state." If that phrase is determined to refer to the location of the insurer, then insurers may simply transact business in states that have not adopted the Model Legislation. If it is held to refer to the insured, and many populous states adopt the Model Legislation, then the Model Legislation could significantly impair transaction volume.
Potential Implications of the Model Legislation
- Regulatory conflict and ambiguity. American Council of Life Insurers (ACLI) Vice President and Chief Counsel Carl B. Wilkerson submitted comments at an NCOIL hearing to the effect that multiple different state and federal initiatives present the risk of "profound regulatory conflicts and redundancies that could thwart responsible risk management of life insurers' assets and liabilities."17 SIMFA and ISDA similarly warn in their joint letter to NCOIL that borrowing specific elements of financial guaranty insurance law, as the Model Legislation proposes to do, would create regulatory ambiguity and inconsistency with respect to other state and federal regulatory regimes.
- Fewer players. A "covered-only" CDS market would have fewer players, which could particularly affect hedge funds, energy companies, and other corporations. These entities could not buy protection unless they own the referenced obligation, and they could not sell protection unless they were able to capitalize an entity with $150 million of "minimum surplus to policyholders." Among existing CDS protection sellers, only banks, which are currently required to maintain capital reserves, would likely be able sell protection.
- Potential Elimination of CDS Market. SIFMA/ISDA stated in their joint letter of May 22 that the Obama Administration has proposed to deal with systemic risk, liquidity, counterparty credit risk, and transparency in over-the-counter derivatives, including credit default swaps, with increased standardization, clearing through centralized counterparties, robust collateral requirements, reporting requirements, and increased federal regulatory oversight. They noted that the Administration's proposal addresses the concerns raised by NCOIL and also provides a framework for effective use of credit default swaps, thus maintaining the benefits of those contracts. They wrote, "In contrast, the NCOIL model legislation risks effectively eliminating the domestic CDS market or, at best, creating a patchwork of legislation with state-based variations."18
- Potential harm to companies and local economies. SIFMA and ISDA stated in their joint letter to NCOIL that the Model Legislation would adversely affect commercial, industrial, and other companies that benefit from credit default swaps, as well as banks and other financial firms that act as CDS dealers, and might cause financial institutions to move their CDS businesses out of state or offshore, harming local economies.
Federal Initiatives Regarding Credit Default Swaps
NCOIL's actions come amid widespread attention to regulation of the over-the-counter (OTC) derivatives market.
- Obama Administration. Regulatory oversight for over-the-counter derivatives market is a significant component of the Obama Administration's response to the financial crisis and plans for reforming the financial markets. The Administration's White Paper, released June 17, 2009, set forth a regulatory framework for regulation of over-the-counter derivatives. This framework was substantially similar to the OTC derivative proposals unveiled by Treasury Secretary Geithner on May 13, 2009, as reported in Sonnenschein's client alert, Treasury Proposes Regulatory Reform for Over-the-Counter Derivatives. Secretary Geithner is expected to release details on this regulatory framework on Friday, July 10, 2009, when he is scheduled to testify before a congressional joint committee hearing to be held by the U.S. House's Agriculture and Financial Services Committees.
- Proposed federal legislation. Various pieces of federal legislation have been proposed in the past six months to address regulation of over-the-counter derivatives, including credit default swaps. On January 15, 2009, Senate Agriculture Committee Chairman Tom Harkin (D-IA) introduced the Derivatives Trading Integrity Act of 2009. On February 11, 2009, House Agriculture Committee Chairman Collin Peterson (D-MN) introduced The Derivatives Markets Transparency and Accountability Act of 2009. On May 4, 2009, Sen. Carl Levin (D-MI) and Sen. Susan Collins (R-ME) introduced the Authorizing the Regulation of Swaps Act.
- ACES Act - the "Cap and Trade" Bill. On June 26, 2009, the U.S. House of Representatives narrowly passed the American Clean Energy and Security Act of 2009 (the ACES Act), which was introduced earlier this year by Energy and Commerce Committee Chairman Henry Waxman (D-CA) and Select Committee on Energy Independence and Global Warming Chairman Ed Markey (D-MA). Though this bill is concerned primarily with climate change matters, it contains several provisions which relate to the OTC derivatives market as a whole. See Sonnenschein's client alert on the derivatives provisions in ACES Act - Derivatives Provisions in Climate Change Bill.
- NYSID to Defer to Federal Efforts. As noted above, the NYSID has decided to postpone indefinitely its attempt to regulate credit default swaps as insurance, provided the Superintendent of Insurance is satisfied with regulatory efforts at the federal level. The NYSID thus seems to share the view of the Obama Administration, the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Federal Reserve, that credit default swaps should be regulated at the federal level.
- NCOIL has taken a different approach. NCOIL President New York State Senator James Seward said of the developments at the federal level, "While we welcome an opportunity to discuss CDS with the new Administration and with our Congressional colleagues, we believe that it is the states that must develop the regulatory framework. As we draft legislation, we would think that Congress would encourage, not override, this desperately needed reform."19 New York Assemblyman Joseph Morelle, Chair of the Task Force and Chair of NCOIL's Financial Services & Investment Products Committee, added that "state regulators, with their extensive experience at regulating insurance products, are extremely qualified to regulate covered credit default swaps as insurance products."20
NCOIL's Summer Meeting, July 9-12
The Task Force's efforts to impose a state-level insurance regulatory system have continued to progress. The Model Legislation is billed as one of the key laws slated for NCOIL's summer meeting in Philadelphia later this week. The Task Force is scheduled to present the Model Legislation to NCOIL's Financial Services & Investment Products Committee on Thursday, July 9, 2009. The Financial Services & Investment Products Committee will then vote on whether to present it to NCOIL's Executive Committee for adoption on Sunday, July 12, 2009. NCOIL's July Newsletter observes that "[a]doption of the model ... is anticipated."21