On September 22, 2008, New York Governor Paterson and the New York Insurance Department (the “Insurance Department”) sent shockwaves around the derivatives industry by announcing that, beginning on January 1, 2009, the Insurance Department would regulate certain credit default swaps (CDS) as a form of financial guaranty insurance, at least when the CDS is issued in New York or issued to a New York purchaser who “holds, or reasonably expects to hold, a ‘material interest’ in the reference obligation.”1 Characterizing the unregulated CDS market as “a major contributor to the emerging financial crisis on Wall Street,” Governor Paterson also called on the federal government to regulate the portion of the CDS market that the Insurance Department’s action does not reach. The following day, in an appearance before the Senate Committee on Banking, Housing, and Urban Affairs, Securities and Exchange Commission (SEC) Chairman Cox urged Congress to provide statutory authority for regulation of the CDS market.2

What Has the Insurance Department Done?

Governor Paterson and the Insurance Department’s announcement accompanied the release of Circular Letter No. 19 (2008) (“Circular 19”). Circular 19 specifies best practices for financial guarantee insurance companies (FGIs), focusing in particular on protection issued by FGIs on collateralized debt obligations (CDOs) of asset-backed securities (ABS) and on CDS. The best practices, including the Insurance Department’s new position regarding CDS, will be effective on January 1, 2009. As necessary, the Department also intends to issue regulations and obtain legislation to formalize the best practices.

Most notably for participants in the credit derivatives market, Circular 19 establishes that certain CDS are insurance products. Given the importance of New York to the nation’s financial system, this position may have wide-reaching impact on the credit derivatives market and its participants. According to the press release accompanying Circular 19, the Insurance Department delayed the effective date of the best practices with respect to CDS to avoid market disruption.

To remedy the lack of regulation of CDS cited by Governor Paterson and the Insurance Department as a key factor in the financial crisis, the Insurance Department will be characterizing certain CDS, namely those for which the buyer of protection “holds, or reasonably expects to hold, a ‘material interest’ in the reference obligation,” as insurance contracts. Circular 19 counsels entities who sell protection under CDS to seek an opinion of the Insurance Department’s Office of General Counsel (OGC) as to whether their CDS activities require a license.

The parallel between CDS and insurance contracts is evident and well known. Both involve one party agreeing to make payments to another party upon the occurrence of specified adverse events. The key difference, articulated and relied upon by the Insurance Department in prior opinions regarding derivative contracts, is that payment under an insurance contract is conditioned on the beneficiary suffering an actual loss in order to be paid. A CDS does not require an actual loss as a condition of payment. A June 16, 2000, opinion of the OGC involving a cash-settled CDS and an earlier OGC opinion dated February 15, 2000, on a weather derivative centered around the absence of the condition of an actual loss in concluding that neither derivative was an insurance contract. Until the release of Circular 19, the credit derivatives industry relied on that key difference as expressed in the OGC’s opinions.

The Insurance Department has now changed its position on treatment of CDS. Neither the cash-settled nature of the CDS in the June 16, 2000, opinion nor the character of the weather derivative in the February 15, 2000, opinion factored into the OGC’s earlier conclusions. The Insurance Department acknowledges in Circular 19 that the OGC opinions from 2000 did not focus on whether the buyer of protection, at the time it enters into the contract, holds or expects to hold an interest in the reference obligation. According to Circular 19, that omission will be addressed in a future OGC opinion.

What Issues Are Raised by the Insurance Department’s Action?

The Insurance Department’s new position raises difficult issues. First, by expanding the scope of insurance contracts to include some CDS, the Insurance Department potentially brings under its jurisdiction all sellers of protection in the credit derivatives market (at least those with sufficient New York nexus), including banks, brokers and affiliates of both, and hedge funds. The Insurance Department’s concern, expressed in Circular 19, is to protect policy holders and ensure that insurance companies have sufficient capital and reserves to meet their obligations. By characterizing CDS as insurance contracts, however, the Insurance Department may also bring under its jurisdiction entities that have a different constituency than insurance companies and which are subject to a different set of laws and regulations to protect those constituencies.

Second, the Insurance Department’s description of covered CDS presents a practical difficulty. Circular 19 refers to contracts for which the buyer of protection holds or may be reasonably expected to hold an interest in the reference obligation. Unanswered is the question as to the level of due diligence the seller of protection must undertake to determine the composition of the buyer’s portfolio and its intention in purchasing additional assets.

How Is the Industry Reacting to This Development?

Derivative industry efforts are underway to address the issues raised by Circular 19. The International Swaps and Derivatives Association (ISDA) is organizing meetings with the Insurance Department and other departments of New York State government to discuss Circular 19. In addition, ISDA is gathering data on how New York would be affected if the credit derivatives business moved elsewhere in response to CDS being regulated as insurance contracts. The extent of ISDA’s success in modifying the Insurance Department’s position will be important for the credit derivatives industry. Notably, ISDA’s efforts were instrumental in leading to the SEC’s modification of its recent short sale ban to permit derivatives market makers to use short sales to hedge their positions. The short sale order, as originally released, threatened to close down much of the over-the-counter equity derivatives market because it choked off the ability to hedge many of the derivatives contracts.3

What Is the SEC’s Position?

The SEC’s Division of Enforcement currently uses its antifraud authority to pursue certain market participants,4 but the CDS industry is otherwise unregulated by the SEC. In his testimony before the Senate Banking Committee, SEC Chairman Cox asked Congress for the authority to regulate CDS contracts “for the protection of investors and to ensure orderly markets.” Chairman Cox characterized the protection buyer’s position in a CDS contract as the economic equivalent of a short sale of the bonds of the obligor referenced in the CDS. Where the buyer of protection does not own bonds of the reference obligor, the buyer of protection is effectively entering into the economic equivalent of an uncovered short position on the reference obligor’s bonds.5

What Other “Best Practices” Does the Insurance Department Recommend?

In addition to bringing certain CDS under the Insurance Department’s regulation, Circular 19’s best practices include the following:

  •  FGIs may not insure pools of ABS that include other pools of ABS unless the FGI’s position or the nature of the assets in the pool meet specified characteristics.
  •  Insurance of CDS should include only transactions with risk comparable to the risk of directly insuring bonds, including failure to pay due to financial default or insolvency, but not due to a change in the creditworthiness of an FGI providing credit support for a CDS counterparty, and not including transactions in which the insurer must post collateral.
  •  In determining compliance with single risk limits in the context of ABS, FGIs should take into account, in addition to the issuer of the securities, the initial lender and servicer of each category of obligations in the underlying collateral.
  •  At least 95 percent of the structured finance portion of an FGI’s portfolio should be investment grade.
  •  An FGI should maintain sufficient liquidity to pay claims, appropriate risk underwriting policies and procedures to protect the FGI’s capital strength, and dynamic risk management.
  •  The Department will seek an increase in the statutory minimum for: (i) paid-in capital from $2.5 million to $15 million, (ii) paid-in surplus from $72.5 million to $165 million, and (iii) surplus to policyholders from $65 million to $150 million.
  •  Capital and contingency reserves required for insurance of ABS that are split into tranches is increased over usual requirements where the FGI insures only the lower tranches.
  •  Additional reporting requirements are imposed, including reporting the failure to comply with Circular 19 and providing specified information intended to enhance the Insurance Department’s oversight ability.


The Insurance Department has made clear its concerns with respect to CDS and the strength of FGIs going forward. Circular 19 is the first step in its efforts to take control of the circumstances that led to the financial crisis. The SEC’s request for authority to regulate CDS may be the start of a new Congressional debate regarding derivatives products. The issues raised for the derivatives industry by Circular 19 and by the SEC’s request for regulatory authority may be clarified over the next few months as the Insurance Department considers further opinions, regulations and calls for legislation, as Congress considers the SEC’s request, and as the derivatives industry seeks to influence decisions so that these new actions are not detrimental to the industry.