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Credit Default Swaps, Guarantees and Insurance Policies: Same Effect, Different Treatment?

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Credit Default Swaps, Guarantees and Insurance Policies: Same Effect, Different Treatment? KEY POINTS Feature Credit default swaps ('CDSs'), guarantees and insurance policies are commonly used in the financial markets to provide protection from the failures of obligors. Banks in particular need to ensure that CDS and guarantees are not treated as insurance policies. Care needs to be taken in structuring transactions to achieve the desired characterisation. Author Leonard Ng Credit default swaps, guarantees and insurance policies: same effect, different treatment? INTRODUCTION This article examines the issue of how credit default swaps, guarantees and insurance Credit default swaps (‘CDS’), policies are used to achieve similar aims in respect of credit protection, but which guarantees and insurance policies need to be characterised in particular ways so as to avoid certain outcomes which are used regularly by financial institutions may be undesirable for the parties involved. seeking to protect themselves from counterparty failures or, in the case of CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES GUARANTEES SWAPS, CREDIT DEFAULT CDS, also to engage in speculative trading the US, which will apply to specific types of Finally, from an accounting perspective, or arbitrage activity. However, the proper derivative contracts. For example, the proposed contracts with the characteristics of insurance characterisation of such instruments can EU Regulation on Short Selling and Credit contracts appear to be treated differently from be important from a legal, regulatory and Default Swaps will regulate CDS of sovereign those which do not, including ‘typical’ CDS. In accounting perspective. debt and contains a definition of ‘credit default particular, certain types of financial contracts swaps’. In addition, new regulations on the are subject to mark-to-market or fair value WHY PROPER CHARACTERISATION clearing of OTC derivatives (of which CDS accounting while other contracts containing MATTERS are a sub-category) and changes to the Basel insurance-like characteristics are not. The proper characterisation of credit regulatory capital framework in respect of derivatives, guarantees and insurance policies OTC derivative exposures may mean banks CONTRACTS OF INSURANCE UNDER is important for a number of reasons. may look for alternatives to OTC derivatives. THE UK REGULATORY REGIME From a regulatory perspective, if a bank in Next, one effect of a CDS or guarantee Article 10 of the Financial Services and the UK purports to provide credit protection being (re)characterised as a contract of Markets Act 2000 (Regulated Activities) Order under a ‘CDS’ or a ‘guarantee’, but in fact the insurance is that insurance contracts impose a 2001 (the ‘RAO’) provides that the activities of contract is one of insurance, then that bank may duty of utmost good faith and full disclosure; ‘effecting a contract of insurance as principal’ be in breach of the UK Financial Services and a failure by the insured in respect either duty and ‘carrying out a contract of insurance as Markets Act 2000 (the ‘FSMA’), because banks may result in the insurer being able to avoid principal’ are regulated activities and thus are not authorised by the Financial Services the contract. subject to the requirement for authorisation Authority (FSA) to carry on insurance business. Formal requirements are also applicable under the FSMA. The RAO does not, Conversely, pursuant to para 1.5.13R only to certain types of contracts. In the however, define ‘contract of insurance’ in of the Prudential Sourcebook for Insurers current context, s 4 of the Statute of Frauds any meaningful way; it defines ‘contract of (‘INSPRU’) contained in the Handbook of 1677 requires that a ‘special promise to insurance’ simply to mean ‘any contract of the Financial Services Authority insurance answere for the debt default or miscarriages insurance which is a contract of long-term companies are prohibited from engaging in of another person’ (ie a guarantee) may not insurance or a contract of general insurance ...’ business other than insurance business. Thus be enforced unless the relevant agreement is In Chapter 6 (Guidance on the Identification INSPRU 1.5.13R would prohibit a FSA in writing and signed by or on behalf of the of Contracts of Insurance) of the FSA Perimeter authorised insurance company from carrying guarantor. Such a requirement does not apply Guidance (‘PERG 6’), the FSA acknowledges on investment business, including providing to contracts of insurance (although it would be that, in order to determine whether any credit protection via a credit derivative. For the difficult to envisage insurance contracts used particular contract is a contract of insurance, same reason, banks are not authorised to carry in the financial markets being otherwise than one must look to the English courts for on insurance business since such authorisation in writing). guidance, and that it is for the courts (and, would in effect prevent banks from engaging in From a tax perspective, if a guarantee therefore, the position under common law), banking business. or a CDS were to be recharacterised as an rather than the FSA, to determine whether or New regulations are also currently being insurance contract, the protection fees paid not there exists a contract of insurance. promulgated, both in the European Union by the protection buyer may be subject to There is no single definition of ‘contract of and other significant jurisdictions such as insurance premium tax. insurance’ under common law, but the case of 664 December 2010 Butterworths Journal of International Banking and Financial Law CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES GUARANTEES SWAPS, CREDIT DEFAULT Feature Prudential v Commissioners of Inland Revenue respect of the reference entity. The credit of insurance if the protection seller would be [1904] 2 KB 658 is often cited as a starting event will usually include the failure to required under the terms of the CDS to make point in providing a definition. In Prudential, pay, bankruptcy or restructuring of the a payment to the protection buyer even where Channell J identified three elements as being reference entity. The protection buyer pays the relevant credit event (eg a failure to pay necessary for a contract to be considered to be a regular (typically quarterly) payment on the part of the reference entity) resulted one of insurance: (effectively, a fee or premium) to the in no loss or detriment being suffered by the (a) ‘[i]t must be a contract whereby for some protection seller throughout the life of the protection buyer. consideration, usually but not necessarily CDS. A CDS is documented under the On that basis, the approach generally for periodical payments called premiums, standard form agreements published by taken in CDS transactions since the issuance you secure to yourself some benefit, the International Swaps and Derivatives of the Potts opinion has been to structure usually but not necessarily the payment Association (‘ISDA’). the CDS to include a specific clause of a sum of money, upon the happening of In 1997, ISDA asked the late Robin Potts providing that there is no requirement for some event’; QC to opine on whether credit derivatives the protection buyer to hold the reference (b) ‘… the event should be one which involves were insurance contracts. ISDA asked Potts asset or to suffer a loss in order to make a some amount of uncertainty. There must QC to consider, specifically, CDS, credit- claim under the CDS. The aim of such a be either uncertainty whether the event linked notes and total return swaps’/credit structural feature and provision is to show will ever happen or not, or if the event spread swaps. The resulting opinion has come that, at the time the credit event occurs, the is one which must happen at some time to be known in the financial services industry protection buyer might not be the holder there must be uncertainty as to the time simply as the ‘Potts opinion’. of the reference asset, so that the loss or at which it will happen’, and In his opinion, Potts QC cited, amongst detriment arising from the credit event might (c) ‘… the insurance must be against others, the Prudential case for the proposition be suffered not by the protection buyer but something … The insurance is to provide that the insurance must be against an rather by the person holding the reference for the payment of a sum of money to uncertain event which is prima facie adverse to asset at the relevant time. This is particularly meet a loss or detriment which will or the interest of the payee, and concluded that: true of CDS which have been entered may be suffered upon the happening of into for hedging purposes (as opposed to the event’. ‘A contract is only a contract of insurance speculative trading or capital arbitrage), if it provides for payment to meet a loss or since the protection buyer is seeking credit The first two elements of thePrudential detriment to which the payee is exposed. protection under the CDS precisely because case are quite likely to be present in most In the case of credit default options it holds the reference asset and has an credit protection contracts including CDS the payment falls to be made quite exposure to the reference entity. and guarantees, but as discussed below, irrespective of whether the payee has It should not be assumed, however, that it is usually the third element that is used suffered loss or ever been exposed to the the mere insertion of such a clause means to support an argument that a particular actual risk of loss.’ that the CDS would not be characterised as a contract either is or is not a contract of contract of insurance. Amongst other things, insurance. Potts QC then went on to opine that: the right of the protection buyer to transfer Before proceeding further, it is worth the reference asset to a third party might noting that, while the English courts will give ‘credit default options plainly differ from be considered to be illusory if in fact it is due regard to the form of contract chosen by contracts of insurance in the following impossible for the protection buyer to do so.
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