CDS Market and Insurable Interest

I’m not the first to bring up the issue, but it doesn’t take away from its importance. When buying life insurance, the idea of insurable risk seems logical. An insurance company will only write a contract to a person with some interest in the life being insured (family member, business partner, etc.). Additionally, the company will only write the contract up to the amount of financial loss that might be incurred by that party. In this way, the market is actually limited by 1. the connections determined to include “interest” and 2. the amount of financial loss that might be incurred.

Without this limitation, insurance companies would write contracts for unlimited amounts (because they would want the premiums) and with no concern for connections (sell to as many people ON as many people as possible). The implications would be a market that has unlimited moral hazard (buyers of insurance would want to kill those on whom they have policies) and a market that is dependent on the insurance companies actually being able to pay of the unlimited policies. Sounds ridiculous in the life insurance market…and it is. It is no longer insurance, but rather, speculation.

The problem is that this is the way the CDS market works. Anyone can buy an insurance policy on the “life” of a company, without regard for insurable interest. Because there is no connection between contracts and insurable interest, the value outstanding of CDSs dwarfs the underlying companies. As long as companies don’t “die”, or die slowly, everyone is happy. The insurance companies that write the contracts (might be insurance companies like AIG, might be investment banks or others) are happy because they are collecting premiums. The buyers are making a speculative bet on the underlying (in reality they are also speculating on the viability of the contract writer), so they are satisfied as long as they feel they’ll be paid if the deed happens.

Unfortunately for the markets as a whole, the risk to the insurance companies continually grows at the same time as they seem more profitable. In the end, the speculation ends as expected: some companies fail, the insurance company can’t pay, leads to the buyer failing, and on and on. That is what we had with AIG/Bear/Lehman etc. and the government stepped in to pay the insurance companies liabilities. A shame, since the liabilities probably shouldn’t have been there at those sizes to begin with.

So what is the next step — I wouldn’t want to own CDS contracts right now, nor would I want to invest in anyone writing these contracts. Both parties will fail. In my estimation, the reform that will be coming will include some insurable interest clauses for generating new contracts. If regulators are smart, they will use a “principle-based” approach, rather than their traditional bias for “rule-based” approaches. In a principle based approach, intenet and context impact how decisions should be made. In a rule-based approach regulators specify what can and cannot be done. The problem with the latter is that once you specify, it leaves loopholes so that companies can work around it much easier. The danger is that any regulation might also limit all derivative markets in unexpected ways, but that is the risk we’ll have to take.

http://seekingalpha.com/article/99455-time-to-rethink-the-doctrine-of-insurable-interest-in-light-of-cds