KEY POINTS Feature  swaps ('CDSs'), guarantees and policies are commonly used in the financial markets to provide protection from the failures of obligors.  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 perspective, or activity. However, the proper . For example, the proposed contracts with the characteristics of insurance characterisation of such instruments can EU Regulation on 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. 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 WHY PROPER CHARACTERISATION 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 in Next, one effect of a CDS or guarantee Article 10 of the and the UK purports to provide credit protection being (re)characterised as a 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 . 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 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 -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 . 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 perspective, if a guarantee therefore, the 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 CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES 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 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. , 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 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. the parties to the arrangement, the form of critical respects: In this regard the FSA noted in its Discussion the contract is not decisive in determining Paper on Cross-sector Risk Transfers (May whether a particular contract is a contract of (1) the payment obligation is not 2002) that: ‘Where the reference event is insurance (eg Fuji Finance Inc. v Aetna Life conditional on the payee’s sustaining a defined in such a way that it is conceptually Insurance Co. Ltd [1997] Ch. 173). loss or having a risk of loss; impossible, at the time the contract was entered into, for the event to occur without CDS COMPARED WITH INSURANCE (2) the contract is thus not one which the protection buyer suffering a loss, the CONTRACTS seeks to protect an insurable interest on contract may well be insurance. (This might Broadly speaking, under a CDS the parties the part of the payee. His rights do not be the case where, for example, the protection agree that, in relation to a reference asset depend on the existence of any insurable buyer was buying protection on a that he issued by a reference entity (eg a corporate interest.’ had originated, which was not transferable or issued by BP plc), the protection seller liquid).’ will make a ‘credit protection payment’ to That is, Potts QC was of the view that a In addition, given that Potts QC’s view the protection buyer upon a ‘credit event’ in CDS should not be characterised as a contract hinged on the ‘insurable interest’ issue, it

Butterworths Journal of International Banking and Financial Law December 2010 665 Biog box Feature Leonard Ng is a partner in the Financial Service Regulatory Group at Sidley Austin LLP in London. Email: [email protected]

is worth noting that the Law Commission First, under a guarantee, the guarantor In recent years there has been an and the Scottish Law Commission (the agrees to perform the obligations of the increasing use of ‘fi nancial guarantees’. ‘Commissions’) published, in January debtor (also called the principal) should the Amongst other things, fi nancial guarantees 2008, an ‘issues paper’ on the subject of debtor fail to perform its obligations to the are exempt from fair value (mark to market) insurable interest, and raised the question creditor. In contrast, in an insurance contract accounting under Statements of Financial as to whether the concept of ‘insurable the insurer reimburses or indemnifi es the Accounting Standards (‘FAS’) No. 133 interest’ should be reformed in some way. creditor for loss shown to be suff ered by the (Accounting for Derivative Instruments Th e Commissions noted the FSA’s view in creditor upon the occurrence of one or more and Hedging Activities) or International its Policy Statement 04/19 (July 2004) that events specifi ed in the insurance contract. Accounting Standard (‘IAS’) No. 39 insurable interest was a requirement for a In this regard, the guarantor’s obligation (Financial Instruments: Recognition and valid contract of insurance, but was ‘not itself under the guarantee is secondary to the Measurement). a defi ning feature’ of a contract of insurance. primary obligation that the debtor has to the However, it would generally be diffi cult, Th e FSA’s guidance in PERG 6 does not creditor under the contract. Th e for example, simply to take the contractual refer to the concept of insurable interest. guarantor’s liability is co-extensive with that terms of a CDS from an ISDA standard of the debtor; if the underlying contract is form agreement and reorganise them under a GUARANTEES COMPARED WITH void, illegal or discharged, the guarantor does document referred to as a ‘guarantee’ with a

CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES GUARANTEES SWAPS, CREDIT DEFAULT INSURANCE CONTRACTS not have any obligation under the guarantee view to classifi cation as a ‘fi nancial guarantee’ A guarantee serves to perform a similar and the creditor cannot make a claim under under FAS 133 or IAS 39. Amongst other function to an insurance contract in that the guarantee. An insurer’s obligation, on things, in order for an instrument to be a ‘fi nancial guarantee’ under FAS 133 or IAS 39, the relevant protection provider must "Financial guarantees’ are sometimes referred to as under the relevant contract reimburse the ‘fi nancial guarantee insurance policies’." holder for a loss it incurs because a specifi ed debtor fails to make payment when due. It is this requirement for a reimbursement of loss that generally makes it diffi cult for a both contracts purport to protect the the other hand, is primary; that is, it exists fi nancial guarantee to be characterised as a relevant creditor from the failure of a regardless of the status of the underlying ‘guarantee’ rather than an insurance policy; debtor to perform its obligation under a contract between the debtor and the creditor. indeed, ‘fi nancial guarantees’ are sometimes contract. To that end it is not always easy Secondly, guarantees tend to be tripartite referred to as ‘fi nancial guarantee insurance to distinguish between the two types of arrangements, involving a debtor, the policies’. contract. In a case often cited in relation guarantor and the creditor; the debtor usually to the distinction between guarantees and applies to the guarantor for the guarantee. CONCLUSION insurance, Seaton v Heath [1899] 1 QB 782, Insurance contracts are bipartite in nature; Th is article has focussed on comparing Romer LJ noted that: the debtor is usually not even aware that the CDS and guarantees with insurance creditor has sought protection from the insurer. policies, but there are other contracts which ‘… the diff erence between these two It should be noted, however, that on at least one raise equally interesting questions. For classes of contract does not depend occasion the English courts have recognised the example, this article has not considered upon any essential diff erence between possibility of bipartite guarantees (eg Owen v longevity derivatives, which reference the word ‘insurance’ and the word Tait [1976] 1 QB 402). mortality risk and for which issues of ‘guarantee’. Th ere is no magic in the Th irdly, in traditional guarantees the contingency (as opposed to ) use of those words. Th e words, to a guarantor is not paid a fee for providing the insurance may need to be considered. What great extent, have the same meaning guarantee or, if a fee is paid, it is paid by the seems clear is that, given the heightened and eff ect; and many contracts, like the debtor to the guarantor. In contrast, under an scrutiny of CDS and other credit protection one in the case now before us, may with insurance policy a premium is usually payable, arrangements since the advent of the global equal propriety be called contracts of and this is paid by the creditor to the insurer (as fi nancial crisis, not only from regulatory insurance or contracts of guarantee.’ noted above, the debtor may not even know of but also from accounting bodies, fi nancial the existence of the insurance taken out by the institutions are likely to be considering the However, there are certain characteristics creditor). However, the courts have recognised issues discussed in this article more closely of each type of contract (apart from the fee-based guarantees as contracts of guarantee than before in order to avoid unintended forms of contract used) that may be helpful (eg International Commercial Bank v. Insurance and potentially undesirable legal, regulatory in distinguishing between them. Corporate of Ireland [1991] ILRM 726 at 736). or accounting consequences. 

666 December 2010 Butterworths Journal of International Banking and Financial Law