Wednesday, September 2, 2009

Credit Derivatives Are Not 'Insurance'

Posted on SSRN by M. Todd Henderson:

According to the conventional wisdom, credit derivative contracts are a form of insurance. This view is held by academics, pundits, journalists, and government officials. This essay shows why they are wrong.

While there is some superficial similarity between some kinds of credit derivative contracts and insurance contracts - both involve payments by a party holding a risk to another party in return for a promise to make the first party whole under certain future conditions - providing risk-sharing does not make a contract one of insurance.

All contracts involve allocating risk between parties, and the lines between insurance contracts and other contracts cannot be sensibly drawn in the abstract. Moreover, the primary reason insurance contracts are treated differently than other contracts (and 'insurance law' is a separate body of law) is not because of their nature as 'insurance' but rather because they are issued by insurance companies.

We regulate insurance companies with special rules for three reasons: (1) the inverted production cycle of insurance; (2) the unique governance problems inherent in a model in which the firm's creditors are policyholders; and (3) a view that state-based consumer protection is important to ensure a functioning market.

This essay shows that none of these policy justifications obtain in credit derivative markets. Finally, the essay briefly discusses how a centralized clearinghouse or exchange can help improve the credit derivatives markets, as well as potential pitfalls with this solution.

The essay can be downloaded here.

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