CDS & Indemnity Insurance
From a legal point of view the private insurance contract in particular in indemnity insurances, and the contract of Credit Default Swaps (CDS) have a common essential characteristic: “the transfer of risk” from one person to another in return of a consideration.
(Speech delivered by Prof. Dr. I. Rokas at the XIIIth AIDA World Congress, Paris 17-20 May 2010; AIDA Europe Colloquium, 20 May 2010)
1. From a legal point of view the private insurance contract in particular in
indemnity insurances, and the contract of Credit Default Swaps (CDS) have a
common essential characteristic: “the transfer of risk” from one person to another
in return of a consideration.
2. CDS buyer agrees to pay a preset amount (premium, also called CDS
spread) and CDS seller agrees to pay to the CDS holder the loss of the nominal value
of an underlying debt obligation, such as a Collateral Debt Obligation (CDOs) or
other titles in case a default as determined in the CDS contract (“credit event”)
occurs, in other words in case of materialization of the credit risk, which is the loss
of some or all of the value of the underlying. The default/ credit event typically
includes payment default, downgrade, any kind of restructuring or bankruptcy of the
underlying obligation or its issuer. It is to be noted that CDS can be traded Over The
Counter (OTC) and that the value (price) is primarily determined by the probability
of default (of the underlying obligation at the time of trading). For example if on
January 1st 2010 the probability of default or the credit rating of the issuer (of the
underlying obligation) is AA the price (spread) of the CDS is 100.000 € and on March
1st the credit rating is lowered to BBB the price of this CDS will be 400.000 €. The
CDS holder can then either sell it with a profit of 400.000 – 100.000 = 300.000 € or
hold it to maintain his protection against the credit event of the underlying.
3. Similarly, credit risk can be transferred to an insurer as far as such risk can be
marketed within the insurance industry (other forms of financial loss of class 16
“miscellaneous financial loss” of the non-life insurances). However there exist also
important differences in other essential characteristics between the two financial
products, which make the analogical application of insurance rules to CDS not
possible.
4. So, not only does the CDS buyer pay the CDS premium to the seller, but also
he bears the risk of CDS devaluation in case the value of the underlying increases,
which however is not usual in our days (“counter-function”). The “counter function”
of the CDS is contrary to the nature of the coverage of risks by indemnity insurance,
which refers only to losses incurred when the risk materializes (coverage of damages).
5. Further, the transfer of risk via a policy is realized by spreading it among the
“community of the insureds”, while in CDS the risk is transferred to one entity only.
A known test to be followed in order to find out if a contract of transfer of risk is an
insurance and thus should be regulated by the insurance legislation or not, is the
involvement of the community of the insureds.
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