Canada: Applying Insurance Principles to Derivatives

Last Updated: October 1 2010
Article by Frank Palmay

Derivatives brought the world economy to its knees in 2008-09. Great investors such as Warren Buffett have called them weapons of mass destruction. As a result of these events, an enormous effort around the world is being focused on how best to regulate derivatives in order to avoid another destructive event. There are important lessons from the field of insurance carefully developed over the centuries that should be considered in this debate.

A derivative at its core is a promise to pay upon the happening of a future event. Other such promises are at the heart of insurance and gambling contracts. Where a derivative falls in the spectrum between insurance and gambling can make the difference between the derivative being a useful financial instrument or a dangerous one. In the past gambling wagers were against public policy and as such were not recognized as valid enforceable contracts. Over the years courts developed criteria for distinguishing between insurance and gambling contracts. Insurance regulations added additional safeguards. These criteria and safeguards developed over time can be applied to regulate derivatives and would go a long way to avoiding a repeat of the havoc they wreaked on the global financial system.

Courts have insisted that for the contract to be valid as insurance, as opposed to being a wager, the person wishing to be insured must have an insurable interest in the subject matter of the insurance policy. Otherwise, the contract was considered to be a wager and was unenforceable. George Soros recently suggested requiring insurable interests in the case of credit default swaps (CDS). Without this requirement, he called these derivatives "licenses to kill".

Since the days of Edward Lloyd's coffee house on the banks of the Thames river, where from 1688 on those interested in receiving the most up to date news on shipping met, be they ship owners, merchants or "underwriters", those who signed a sheet paper under the bare particulars of the voyage (ship, captain, cargo, ports of call) and thereby assumed a percentage of the risk of the voyage, courts insisted on the duty of outmost good faith on the part of those seeking to obtain the protection of insurance from these underwriters. The courts required truthful and full disclosure of the facts so that the persons taking on the risk could assess it fairly and price the policy written correctly.

The implication of breaching this duty and misrepresenting a material fact in the application for insurance is severe. The underwriter can rescind the whole contract. The sophistication of the underwriter is immaterial. Withholding the information by an applicant for the insurance is all that matters. Had these principles applied to the sub-prime transactions that Goldman Sachs is caught up in (if the allegations against it are true) and to the conduct that according to Michael Lewis's The Big Short underpinned most of the collaterized debt obligation (CDO) market, the losses would have fallen on completely different persons and perhaps the derivative "bets" would never have been made!

Another principle of insurance law enunciated by our courts over the years is the concept of indemnity. A person cannot recover more under an insurance contract than his or her loss – the value of the thing lost or the cost to repair or rebuild it. The only exception is life insurance where understandably courts could not put a monetary value on a person's life. This is an extension of the requirement of insurable interest and like that principle limits the universe of wagers. Derivatives, like synthetic CDO's have no such controls and, therefore, as long as you can find a mark or sophisticated entity to take the other side of the bet, there is no upper limit to the amount that can be "in play" – billions, trillions! And without the governors of the duty of outmost good faith or the consequences of misrepresentation, it is easy or at least easier to find those marks, be they German banks, pension funds or corporate treasuries.

As insurance contracts became ever more complex and insurers more sophisticated from those Lloyd's coffee house underwriters, courts introduced rules of contract interpretation and duties to rebalance the equities, this time in favour of the insureds. They ruled that insuring clauses or those promises to pay, be interpreted broadly and exclusions in the form of clauses seeking to avoid the promise, be interpreted narrowly. Courts have recognized over time that the policies written by insurers were being skewed in favour of the drafters, the insurance companies. Courts therefore introduced the concept of the duty of outmost good faith in the adjusting (settling) of insurance claims. The consequence of breaching this duty is an award of exemplary and punitive damages against the insurance company. How would these principles have impacted the billions that AIG Financial paid?

Insurers are required to set aside capital in the form of reserves to ensure that in the future and in some cases the far future, when it comes time to make good on that promise to pay, the money is there. Over the years with experience and trial and error, a whole science and profession (actuaries) developed to assist in the setting of these reserves and testing their adequacy under various scenarios and stresses. This requirement for capital is the very reason why the activities that brought AIG to its knees were those of its unregulated AIG Financial arm and not those of its regulated insurance operations.

While the principles of insurance cannot avoid all problems and a number of monoline companies providing financial guarantee insurance failed or faltered, the insurance industry by and large weathered the recent financial meltdown quite well and where they ran into difficulties was the very areas where they ventured into the derivative territory.

Finally, having principles as opposed to rules is also another important lesson from the application of common law. As the evolution of derivatives over the years has shown clearly, if there is financial incentive loopholes around rules will be found. As an example, the ever increasing complexity of the income tax codes shows, a rules based system is almost guaranteed to be an endless cycle of finding loopholes, stopping them up and finding new ones. While this topic is much broader than just the regulation of insurance, it is an important adjunct to ensuring that whatever is put in place is flexible enough to evolve in order to address the unanticipated problems and challenges that are sure to arise. This is one of the strengths of the system of common law which develops over time by applying sound principles of the past to new situations and business practices.

The current debate is properly focused on how to avoid a similar economic disaster in the future to the one that derivatives caused in the last three years. There is three hundred years of insurance experience built case by case. We will ignore these principles and lessons at our peril.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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