Credit default swaps, guarantees and insurance policies: same

December 2010 Butterworths Journal of International Banking and Financial Law

664

CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES

Feature

Credit default swaps, guarantees and

insurance policies: same effect, different

treatment?

INTRODUCTION

Credit default swaps (‘CDS’),

guarantees and insurance policies

are used regularly by ﬁnancial institutions

seeking to protect themselves from

counterparty failures or, in the case of

CDS, also to engage in speculative trading

or arbitrage activity. However, the proper

characterisation of such instruments can

be important from a legal, regulatory and

accounting perspective.

WHY PROPER CHARACTERISATION

MATTERS

e proper characterisation of credit

derivatives, guarantees and insurance policies

is important for a number of reasons.

From a regulatory perspective, if a bank in

the UK purports to provide credit protection

under a ‘CDS’ or a ‘guarantee’, but in fact the

contract is one of insurance, then that bank may

be in breach of the UK Financial Services and

Markets Act 2000 (the ‘FSMA’), because banks

are not authorised by the Financial Services

Authority (FSA) to carry on insurance business.

Conversely, pursuant to para 1.5.13R

of the Prudential Sourcebook for Insurers

(‘INSPRU’) contained in the Handbook of

the Financial Services Authority insurance

companies are prohibited from engaging in

business other than insurance business. us

INSPRU 1.5.13R would prohibit a FSA

authorised insurance company from carrying

on investment business, including providing

credit protection via a credit derivative. For the

same reason, banks are not authorised to carry

on insurance business since such authorisation

would in eﬀect prevent banks from engaging in

banking business.

New regulations are also currently being

promulgated, both in the European Union

and other signiﬁcant jurisdictions such as

the US, which will apply to speciﬁc types of

derivative contracts. For example, the proposed

EU Regulation on Short Selling and Credit

Default Swaps will regulate CDS of sovereign

debt and contains a deﬁnition of ‘credit default

swaps’. In addition, new regulations on the

clearing of OTC derivatives (of which CDS

are a sub-category) and changes to the Basel

regulatory capital framework in respect of

OTC derivative exposures may mean banks

may look for alternatives to OTC derivatives.

Next, one eﬀect of a CDS or guarantee

being (re)characterised as a contract of

insurance is that insurance contracts impose a

duty of utmost good faith and full disclosure;

a failure by the insured in respect either duty

may result in the insurer being able to avoid

the contract.

Formal requirements are also applicable

only to certain types of contracts. In the

current context, s 4 of the Statute of Frauds

1677 requires that a ‘special promise to

answere for the debt default or miscarriages

of another person’ (ie a guarantee) may not

be enforced unless the relevant agreement is

in writing and signed by or on behalf of the

guarantor. Such a requirement does not apply

to contracts of insurance (although it would be

diﬃcult to envisage insurance contracts used

in the ﬁnancial markets being otherwise than

in writing).

From a tax perspective, if a guarantee

or a CDS were to be recharacterised as an

insurance contract, the protection fees paid

by the protection buyer may be subject to

insurance premium tax.

Finally, from an accounting perspective,

contracts with the characteristics of insurance

contracts appear to be treated diﬀerently from

those which do not, including ‘typical’ CDS. In

particular, certain types of ﬁnancial contracts

are subject to mark-to-market or fair value

accounting while other contracts containing

insurance-like characteristics are not.

CONTRACTS OF INSURANCE UNDER

THE UK REGULATORY REGIME

Article 10 of the Financial Services and

Markets Act 2000 (Regulated Activities) Order

2001 (the ‘RAO’) provides that the activities of

‘eﬀecting a contract of insurance as principal’

and ‘carrying out a contract of insurance as

principal’ are regulated activities and thus

subject to the requirement for authorisation

under the FSMA. e RAO does not,

however, deﬁne ‘contract of insurance’ in

any meaningful way; it deﬁnes ‘contract of

insurance’ simply to mean ‘any contract of

insurance which is a contract of long-term

insurance or a contract of general insurance ...’

In Chapter 6 (Guidance on the Identiﬁcation

of Contracts of Insurance) of the FSA Perimeter

Guidance (‘PERG 6’), the FSA acknowledges

that, in order to determine whether any

particular contract is a contract of insurance,

one must look to the English courts for

guidance, and that it is for the courts (and,

therefore, the position under common law),

rather than the FSA, to determine whether or

not there exists a contract of insurance.

ere is no single deﬁnition of ‘contract of

insurance’ under common law, but the case of

KEY POINTS



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.

This article examines the issue of how credit default swaps, guarantees and insurance

policies are used to achieve similar aims in respect of credit protection, but which

need to be characterised in particular ways so as to avoid certain outcomes which

may be undesirable for the parties involved.

Author Leonard Ng

Butterworths Journal of International Banking and Financial Law December 2010

665

Feature

CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES

Prudential v Commissioners of Inland Revenue

[1904] 2 KB 658 is often cited as a starting

point in providing a deﬁnition. In Prudential,

Channell J identiﬁed three elements as being

necessary for a contract to be considered to be

one of insurance:

(a) ‘[i]t must be a contract whereby for some

consideration, usually but not necessarily

for periodical payments called premiums,

you secure to yourself some beneﬁt,

usually but not necessarily the payment

of a sum of money, upon the happening of

some event’;

(b) ‘… the event should be one which involves

some amount of uncertainty. ere must

be either uncertainty whether the event

will ever happen or not, or if the event

is one which must happen at some time

there must be uncertainty as to the time

at which it will happen’, and

something … e insurance is to provide

for the payment of a sum of money to

meet a loss or detriment which will or

may be suﬀered upon the happening of

the event’.

e ﬁrst two elements of the Prudential

case are quite likely to be present in most

credit protection contracts including CDS

and guarantees, but as discussed below,

it is usually the third element that is used

to support an argument that a particular

contract either is or is not a contract of

insurance.

Before proceeding further, it is worth

noting that, while the English courts will give

due regard to the form of contract chosen by

the parties to the arrangement, the form of

the contract is not decisive in determining

whether a particular contract is a contract of

insurance (eg Fuji Finance Inc. v Aetna Life

Insurance Co. Ltd [1997] Ch. 173).

CDS COMPARED WITH INSURANCE

CONTRACTS

Broadly speaking, under a CDS the parties

agree that, in relation to a reference asset

issued by a reference entity (eg a corporate

bond issued by BP plc), the protection seller

will make a ‘credit protection payment’ to

the protection buyer upon a ‘credit event’ in

respect of the reference entity. e credit

event will usually include the failure to

pay, bankruptcy or restructuring of the

reference entity. e protection buyer pays

a regular (typically quarterly) payment

(eﬀectively, a fee or premium) to the

protection seller throughout the life of the

CDS. A CDS is documented under the

standard form agreements published by

the International Swaps and Derivatives

Association (‘ISDA’).

In 1997, ISDA asked the late Robin Potts

QC to opine on whether credit derivatives

were insurance contracts. ISDA asked Potts

QC to consider, speciﬁcally, CDS, credit-

linked notes and total return swaps’/credit

spread swaps. e resulting opinion has come

to be known in the ﬁnancial services industry

simply as the ‘Potts opinion’.

In his opinion, Potts QC cited, amongst

others, the Prudential case for the proposition

that the insurance must be against an

uncertain event which is prima facie adverse to

the interest of the payee, and concluded that:

‘A contract is only a contract of insurance

if it provides for payment to meet a loss or

detriment to which the payee is exposed.

In the case of credit default options

the payment falls to be made quite

irrespective of whether the payee has

suﬀered loss or ever been exposed to the

actual risk of loss.’

Potts QC then went on to opine that:

‘credit default options plainly diﬀer from

contracts of insurance in the following

critical respects:

(1) the payment obligation is not

conditional on the payee’s sustaining a

loss or having a risk of loss;

(2) the contract is thus not one which

seeks to protect an insurable interest on

the part of the payee. His rights do not

depend on the existence of any insurable

interest.’

at is, Potts QC was of the view that a

CDS should not be characterised as a contract

of insurance if the protection seller would be

required under the terms of the CDS to make

a payment to the protection buyer even where

the relevant credit event (eg a failure to pay

on the part of the reference entity) resulted

in no loss or detriment being suﬀered by the

protection buyer.

On that basis, the approach generally

taken in CDS transactions since the issuance

of the Potts opinion has been to structure

the CDS to include a speciﬁc clause

providing that there is no requirement for

the protection buyer to hold the reference

asset or to suﬀer a loss in order to make a

claim under the CDS. e aim of such a

structural feature and provision is to show

that, at the time the credit event occurs, the

protection buyer might not be the holder

of the reference asset, so that the loss or

detriment arising from the credit event might

be suﬀered not by the protection buyer but

rather by the person holding the reference

asset at the relevant time. is is particularly

true of CDS which have been entered

into for hedging purposes (as opposed to

speculative trading or capital arbitrage),

since the protection buyer is seeking credit

protection under the CDS precisely because

it holds the reference asset and has an

exposure to the reference entity.

It should not be assumed, however, that

the mere insertion of such a clause means

that the CDS would not be characterised as a

contract of insurance. Amongst other things,

the right of the protection buyer to transfer

the reference asset to a third party might

be considered to be illusory if in fact it is

impossible for the protection buyer to do so.

In this regard the FSA noted in its Discussion

Paper on Cross-sector Risk Transfers (May

2002) that: ‘Where the reference event is

deﬁned in such a way that it is conceptually

impossible, at the time the contract was

entered into, for the event to occur without

the protection buyer suﬀering a loss, the

contract may well be insurance. (is might

be the case where, for example, the protection

buyer was buying protection on a loan that he

had originated, which was not transferable or

liquid).’

In addition, given that Potts QC’s view

hinged on the ‘insurable interest’ issue, it

December 2010 Butterworths Journal of International Banking and Financial Law

666

CREDIT DEFAULT SWAPS, GUARANTEES AND INSURANCE POLICIES

Feature

is worth noting that the Law Commission

and the Scottish Law Commission (the

‘Commissions’) published, in January

2008, an ‘issues paper’ on the subject of

insurable interest, and raised the question

as to whether the concept of ‘insurable

interest’ should be reformed in some way.

 e Commissions noted the FSA’s view in

its Policy Statement 04/19 (July 2004) that

insurable interest was a requirement for a

valid contract of insurance, but was ‘not itself

a deﬁ ning feature’ of a contract of insurance.

 e FSA’s guidance in PERG 6 does not

refer to the concept of insurable interest.

GUARANTEES COMPARED WITH

INSURANCE CONTRACTS

A guarantee serves to perform a similar

function to an insurance contract in that

both contracts purport to protect the

relevant creditor from the failure of a

debtor to perform its obligation under a

contract. To that end it is not always easy

to distinguish between the two types of

contract. In a case often cited in relation

to the distinction between guarantees and

insurance, Seaton v Heath [1899] 1 QB 782,

Romer LJ noted that:

‘… the diﬀ erence between these two

classes of contract does not depend

upon any essential diﬀ erence between

the word ‘insurance’ and the word

‘guarantee’.  ere is no magic in the

use of those words.  e words, to a

great extent, have the same meaning

and eﬀ ect; and many contracts, like the

one in the case now before us, may with

equal propriety be called contracts of

insurance or contracts of guarantee.’

However, there are certain characteristics

of each type of contract (apart from the

forms of contract used) that may be helpful

in distinguishing between them.

First, under a guarantee, the guarantor

agrees to perform the obligations of the

debtor (also called the principal) should the

debtor fail to perform its obligations to the

creditor. In contrast, in an insurance contract

the insurer reimburses or indemniﬁ es the

creditor for loss shown to be suﬀ ered by the

creditor upon the occurrence of one or more

events speciﬁ ed in the insurance contract.

In this regard, the guarantor’s obligation

under the guarantee is secondary to the

primary obligation that the debtor has to the

creditor under the underlying contract.  e

guarantor’s liability is co-extensive with that

of the debtor; if the underlying contract is

void, illegal or discharged, the guarantor does

not have any obligation under the guarantee

and the creditor cannot make a claim under

the guarantee. An insurer’s obligation, on

the other hand, is primary; that is, it exists

regardless of the status of the underlying

contract between the debtor and the creditor.

Secondly, guarantees tend to be tripartite

arrangements, involving a debtor, the

guarantor and the creditor; the debtor usually

applies to the guarantor for the guarantee.

Insurance contracts are bipartite in nature;

the debtor is usually not even aware that the

creditor has sought protection from the insurer.

It should be noted, however, that on at least one

occasion the English courts have recognised the

possibility of bipartite guarantees (eg Owen v

Tait [1976] 1 QB 402).

 irdly, in traditional guarantees the

guarantor is not paid a fee for providing the

guarantee or, if a fee is paid, it is paid by the

debtor to the guarantor. In contrast, under an

insurance policy a premium is usually payable,

and this is paid by the creditor to the insurer (as

noted above, the debtor may not even know of

the existence of the insurance taken out by the

creditor). However, the courts have recognised

fee-based guarantees as contracts of guarantee

(eg International Commercial Bank v. Insurance

Corporate of Ireland [1991] ILRM 726 at 736).

In recent years there has been an

increasing use of ‘ﬁ nancial guarantees’.

Amongst other things, ﬁ nancial guarantees

are exempt from fair value (mark to market)

accounting under Statements of Financial

Accounting Standards (‘FAS’) No. 133

(Accounting for Derivative Instruments

and Hedging Activities) or International

Accounting Standard (‘IAS’) No. 39

(Financial Instruments: Recognition and

Measurement).

However, it would generally be diﬃ cult,

for example, simply to take the contractual

terms of a CDS from an ISDA standard

form agreement and reorganise them under a

document referred to as a ‘guarantee’ with a

view to classiﬁ cation as a ‘ﬁ nancial guarantee’

under FAS 133 or IAS 39. Amongst other

things, in order for an instrument to be a

‘ﬁ nancial guarantee’ under FAS 133 or IAS

39, the relevant protection provider must

under the relevant contract reimburse the

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

ﬁ nancial guarantee to be characterised as a

‘guarantee’ rather than an insurance policy;

indeed, ‘ﬁ nancial guarantees’ are sometimes

referred to as ‘ﬁ nancial guarantee insurance

policies’.

CONCLUSION

 is article has focussed on comparing

CDS and guarantees with insurance

policies, but there are other contracts which

raise equally interesting questions. For

example, this article has not considered

longevity derivatives, which reference

mortality risk and for which issues of

contingency (as opposed to indemnity)

insurance may need to be considered. What

seems clear is that, given the heightened

scrutiny of CDS and other credit protection

arrangements since the advent of the global

ﬁ nancial crisis, not only from regulatory

but also from accounting bodies, ﬁ nancial

institutions are likely to be considering the

issues discussed in this article more closely

than before in order to avoid unintended

and potentially undesirable legal, regulatory

or accounting consequences. 

Biog box

Leonard Ng is a partner in the Financial Service Regulatory Group at Sidley Austin LLP

in London. Email:

lng@sidley.co

"Financial guarantees’ are sometimes referred to as

‘ﬁ nancial guarantee insurance policies’."