At a hearing held by the National Conference of Insurance Legislators (“NCOIL”) on Saturday, January 24, 2009, a panel of state legislators heard testimony from a number of experts regarding the advantages and disadvantages of regulating the credit default swap (“CDS”) market on a state, rather than federal, basis. We have previously reported on the federal government’s plans to regulate the CDS market here.

A major topic of debate at the hearing was whether CDS contracts constitute securities or insurance. Eric Dinallo, New York’s Superintendent of Insurance, stressed the need for a differentiation between “covered” and “naked” CDS contracts. Covered CDS contracts are those that are bought by investors that also own the actual bonds or loans referenced by the swaps. A naked CDS contract, on the other hand, is where the buyer or investor does not own the underlying bond. Mr. Dinallo, and the New York Insurance Department’s position (see here for more detail), is that covered CDS contracts are insurance, because the purchaser transfers risk. By that same reasoning, naked CDS contracts are not considered insurance, because the party accepting the risk offers no guarantee to make an affected party whole, as in an insurance arrangement.

The panel also heard testimony that CDS contracts are similar to letters of credit, which are not regulated as insurance. Others argued that rather than regulate CDS contracts, regulation of rating agencies should be strengthened to ensure more accurate ratings. The rating system has been criticized heavily as of late as approximately $225 billion of “AAA”-rated CDS contracts have defaulted.

Whether CDS market regulation is enacted, either on a state or federal level remains to be seen. NCOIL will decide whether to enact model legislation regulating the CDS market at its spring meeting next month.