On September 22, 2008, the New York Department of Insurance issued Circular Letter No. 19 ("Circular Letter"), establishing, for the first time, that certain credit default swaps will be regulated as insurance products by the New York Insurance Department. The Circular Letter clarifies that if the making of a credit default swap constitutes "the doing of an insurance business" under New York Insurance Law Section 1101, then the New York Insurance Department may determine, based upon the facts and circumstances, that the seller should be licensed as an insurer under New York Insurance Law Section 1102. As such, some credit default swaps can only be issued by properly licensed insurance entities. This is a reversal of the department's 2000 ruling that credit default swaps are not insurance.

A credit default swap is a contract under which the seller of protection on a bond promises to pay certain amounts to the buyer of protection if the issuer of the subject bond does not pay principal and interest on its obligations, files bankruptcy or certain other "credit events" occur. When the buyer of protection owns the bond, the seller essentially provides "insurance" with respect to the payments due on the underlying bond. The New York Insurance Department will consider these types of credit default swaps to be insurance products, and they can only be issued by licensed insurance entities.

The New York Insurance Department will not be regulating so-called "naked swaps," which are typically bought by speculators who do not own the underlying bond and are issued by banks and securities firms, as well as non-regulated affiliates of insurance companies. The Circular Letter is designed to establish "best practices" for financial guaranty and bond insurers, and also to encourage new players to enter the bond insurer market. Lastly, the Circular Letter foreshadows the forthcoming issuance of additional guidance that may draw into insurance regulatory oversight non-insurers who write certain credit default swaps.

The new "best practices" will not affect existing credit default swaps and will not take effect until January 1, 2009. While the Circular Letter is merely guidance, the New York Insurance Department intends to propose new regulations and/or legislation to implement these reform measures.

These new standards:

  • Limit financial guaranty insurers from guaranteeing collateralized debt obligations ("CDOs"), some of which have been based upon subprime mortgage payments;
  • Limit risks for financial guaranty insurers (for example, expanding the sources of risk concentration to include originators and debt servicers);
  • Require written risk control and underwriting guidelines;
  • Increase the minimum capital and reserves required of financial guaranty insurers; and
  • Expand reporting requirements.

Among other things, the New York Insurance Department wants financial guaranty insurers to restrict the issuance of insurance policies that back CDOs of asset-backed securities ("ABS"). Financial guaranty insurers should not insure pools of ABS unless (i) the insurance policy requires that the insurer holds an unsubordinated, senior position, if such position has an investment rating of A or above; (ii) the pool consists only of ABS that are issued or guaranteed by a government-sponsored enterprise; (iii) the pool consists entirely of the portion of other pools of ABS that are already insured by the financial guaranty insurer; or (iv) the New York Insurance Department "has determined that the insurance is without undue risk to" the financial guaranty insurer, its policyholders and the public.

The New York Insurance Department also will seek to change Insurance Law Section 6902 (b)(1) to increase (i) the required paid-in capital for bond insurers from at least $2.5 million to at least $15 million; (ii) the required paid-in surplus from at least $72.5 million to at least $165 million; and (iii) the minimum surplus to policyholders from at least $65 million to in excess of $150 million.

The reform measures also include increased financial reporting obligations, including requiring financial guaranty insurers to report material declines in policyholder surplus.

A copy of Circular Letter No. 19 can be obtained at http://www.ins.state.ny.us/circltr/2008/cl08_19.pdf.