On September 22, 2008, the New York State Department of
Insurance (the "NY Insurance Regulator") issued Circular
Letter No. 19 (2008) (the "Circular") concerning
insurance policies written by financial guarantee insurance
companies on asset-backed securities. In particular, the Circular
focused on insuring asset-backed securities where the underlying
asset is a credit default swap or similar credit instrument. In the
U.S., insurance regulation is governed by each State and not the
Federal government.
A credit default swap is a privately negotiated bilateral contract
where the buyer makes periodic payments to the seller in exchange
for the right to a payment if one or more specified credit events
occurs in respect of a third party's bond, loan or other debt
obligations. Therefore it can be used to protect the buyer against
defaults on third party debt, although buyers often enter into such
contracts even where they do not own the underlying debt.
Currently, credit default swaps are not regulated in the U.S. as
either insurance contracts or securities, though they may be
subject to insider trading and other similar provisions of
securities laws.
Of more significance to non-insurance company participants in the
credit default swap market, is the statement in the Circular that
to the extent that the selling of credit default swap protection
itself may constitute "the doing of an insurance
business" under New York State Insurance Law, the seller
should consider seeking an opinion from the Office of the General
Counsel of the NY Insurance Regulator (the "OGC") to
assess whether it should be licensed as an insurer in New York
State. The OGC issued previous opinions expressly stating that
credit default swaps are not insurance contracts because the buyer
is entitled to a payment without any requirement for proof of loss
upon default under the underlying debt obligation. However, the
Circular points out that such prior opinions did not address the
situation where the buyer actually "holds, or is reasonably
expected to hold, a material interest in the referenced
obligation". The Circular states that a further opinion will
be issued by the OGC where "that omission will be rectified
and addressed". Presumably the opinion will conclude that such
credit default swaps are insurance contracts and therefore New York
State will subject them (and their sellers) to state insurance
regulation. According to a press release issued on the same day by
Governor David Paterson, beginning in January 2009, when a buyer of
a credit default swap owns the underlying reference obligation, the
seller will be considered to be selling an insurance contract, and
therefore will be required to be licensed to conduct insurance
business in New York State.
The Circular and press release make it clear that credit default
swaps written on one named credit in which the buyer of protection
"holds, or is reasonably expected to hold, a material
interest" will constitute insurance contracts under New York
State Insurance Law. However, it is not clear what impact the
forthcoming opinion of the OGC will have on credit default swaps
where there are tens or hundreds of underlying debt obligations or
where the reference obligations are included in an index. It would
be prudent for sellers of credit default swaps to consider
obtaining representations from their buyer stating that such buyer
does not hold, and does not expect to hold, a material interest in
the referenced obligation. While this could be useful in some
limited circumstances, it is impractical for a financial
institution to give such a representation when another desk within
the same institution may have such an interest, particularly where
there are more than a few reference obligations. When a seller of
protection under a credit default swap cannot obtain such a
representation and is either domiciled in New York State, doing
business in New York State or is trading with New York State
counterparties, the Circular raises at least a question as to
whether such trade constitutes engaging in the business of
insurance in New York State without a license.
The NY Insurance Regulator has indicated that it does not wish to
regulate "naked credit default swaps" (credit default
swaps where the buyer does not own the reference debt obligation).
However, the impact of the Circular on the credit default swap
market will remain unclear until the OGC's forthcoming opinion
is issued and a clear meaning can be discerned from it.
Credit default swaps have been implicated in the current credit
crisis so we should expect increased oversight of the credit
default swap market and its participants from the SEC and other
regulators.
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.
