This article originally appeared in the September/October 2008
issue of AKO'S Policyholder Advisor
Credit Default Swaps ("CDS") are part of a $62
trillion market, that have gone from obscure to infamous in a
matter of months, if not weeks. Yet along the way, many people were
left without a clear understanding of what CDS
are—particularly, in what ways CDS are like or unlike
insurance. In brief, a CDS is like insurance insofar as the buyer
collects when an underlying security defaults or loses value in
some other way defined by the contract. It is unlike insurance,
however, in that the buyer need not have an "insurable
interest" in the underlying security.
Defined as Similar to Insurance
A CDS appears a lot like insurance on an investment, in
particular a debt obligation. As one court explained,
A credit default swap is an
arrangement similar to an insurance contract. The buyer of
protection . . . pays a periodic fee, like an insurance premium, to
the seller of protection . . ., in exchange for compensation in the
event that the insured security experiences default.
Merrill Lynch International v. XL Capital Assurance,
Inc., (S.D.N.Y.). The triggering event that causes the Seller
to pay is usually called a "Credit
Event"—usually, though not always, defined to
involve a default on the underlying security. Upon the occurrence
of a Credit Event, the Buyer and Seller settle up in one of two
methods. Under both methods, the Seller will pay to the Buyer the
face value of the underlying debt security. In return, under a
"physical settlement," the Buyer will deliver the
underlying debt security to the Seller, and under a "cash
settlement," the Buyer will offset the Seller's face value
payment by the actual market value of the underlying security,
sometimes determined through an auction.
Despite the differences between a
CDS and insurance outlined below, pursuing recovery under both can
be quite similar. The language of the agreement is very important.
Although standardized forms exist and are commonly used, very often
much of the controlling language will be drafted specifically for
Yet Not Quite Insurance
Yet although courts and other
reference sources almost invariably describe CDS as similar to
insurance, there is a broad consensus that, on the whole, CDS are
not the equivalent of insurance policies.
The two main reasons most often
given to support the conclusion that CDS are not insurance products
are that (1) the Buyer does not have to own the underlying
security, or otherwise have any insurable interest in that
security, and (2) the Buyer does not in fact have to suffer any
loss in order to recover on the CDS. As noted, under some CDS
terms, a "Credit Event" can take place that does not
involve an actual default for the underlying security, and, of
course, if the CDS Buyer does not own the underlying security, it
will not suffer a loss even if there is a loss for actual
bondholders. In addition, a Credit Event could cause the Buyer who
does hold the underlying debt to recover an amount that is greater
than, or less than, any actual loss it suffers. The Buyer's
recovery is determined by the contract terms—the amount
of any loss it suffers is irrelevant.
CDS also differ from insurance
contracts with regard to tax, accounting, bankruptcy and in
regulatory jurisdiction. To date, for example, CDS have not been
subject to state insurance regulations—although this
might soon change. New York State has begun issuing guidelines to
regulate that portion of the CDS market where the Buyer
does own the underlying asset, does therefore
have an insurable interest, and does suffer a loss upon
default. CDS that share these characteristics do not support the
two main reasons that CDS are generally considered not to be
insurance, and New York insurance regulators believe they will be
able to assert their powers over this part of the market.
Mark Garbowski is a senior shareholder and
member of Anderson Kill's insurance recovery group, with
particular experience in professional liability insurance,
directors and officers (D&O) insurance, fidelity and crime-loss
policies, Internet and hi-tech liability insurance issues.
Copyright (c) 2008 Anderson Kill & Olick, P.C., All rights
The information appearing in this article does not
constitute legal advice or opinion. Such advice and opinion are
provided by the firm only upon engagement with respect to specific
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