Credit Derivatives and Insurance .

It is a truth universally acknowledged (well - in the insurance world at least!) that insurance companies cannot enter into derivative contracts (unless the contract is entered into "in connection with or for the purposes of" insurance business - for example, if the insurer is hedging its own portfolio). What an insurer cannot do is enter into a derivative contract for commercial reasons.

This gives rise to a certain friction between what insurers are permitted to do and what they wish to do. It is also an issue for the capital markets who are thereby denied access to the vast capital resources available to many insurance companies which could well facilitate greater volumes of derivative activity.

This friction goes a long way in explaining the current market interest in "transformer" companies. As their name suggests, these are companies which, in effect, "transform" a contract, in this case a derivative contract, into an insurance policy. To understand why these companies are becoming popular, it is worth looking at the underlying issues more carefully.

The Similarities and the Differences

Similarities

Broadly, a credit derivative is a financial instrument designed to assume or lay off credit risk on loans, debt securities or other assets or in relation to a particular entity or country. In return for the laying off of risk, there is a payment from the originating party to the counterparty. Credit derivatives may take the form of credit default options, credit-linked notes or total return swaps, but the product which is most similar to insurance is the credit default swap. Credit default swaps typically pay out on the occurrence of a specified credit event - such as the insolvency of the referenced entity, or a material deterioration in that entity's credit-worthiness.

Compare this, then, to insurance, or more particularly credit insurance, which is defined in the Insurance Companies Act 1982 ("ICA") as being insurance against "loss to the persons insured arising from the insolvency of debtors of theirs or from the failure (otherwise than through insolvency) of debtors of theirs to pay their debts when due". Thus the same or a similar kind of risk could equally well be offset either by a derivative or an insurance product, both being contracts of indemnity and having a similar economic effect.

Differences

Although insurance and derivative contracts can be extremely similar, a derivative contract is not an insurance. One needs to understand the meaning of "insurance" in order to appreciate the difference between the two.

There is no English statutory definition of a contract of insurance but case law has identified certain essential elements as follows:

• there must be a promise to pay;
• the insured must have an insurable interest in the subject matter of the policy;
• what the insured purchases is the right to receive monies on the occurrence of an uncertain event (the key feature being that there must be an element of contingency, either as to the happening of the event or as to its timing);
• there must be a premium passing between the parties.

It is also worth considering the commercial effect of an insurance contract, which is to transfer risk from one party (the insured) to another (the insurer). Where there is doubt as to the correct characterisation, then as with any contract, what is likely to carry most weight with an English court is the substance of the contract as a whole, taken in its commercial context. How the parties choose to describe the contract will be of little persuasive force.

Furthermore, it has been established that either the contract as a whole is a contract of insurance or it is not. Only where the principal object of the contract is to insure will the contract be one of insurance. So a contract which contains an element of insurance which is collateral to its principal purpose will not constitute insurance.

The most important of the above features for the purpose of distinguishing credit insurance from a credit derivative is that the insured must have an insurable interest in the subject matter of the insurance. In other words, the insured must stand to lose financially if the event insured against happens.

The statutory definition of "insurable interest" is as follows:

"a person is interested in [a marine] adventure where he stands in any legal or equitable relation to the adventure or to any insurable property at risk therein, in consequence of which he may benefit by the safety or due arrival of insurable property, or may be prejudiced by its loss, or damage thereto, or by the detention thereof, or may incur liability in respect thereof."

The key concept is that of loss - is the insured's relationship with the matter insured such that he would incur financial loss should the risk insured against occur? If not, then the requirement that there must be an insurable interest is not satisfied. (Nor indeed is the requirement that there be a transfer of risk, since one cannot have a transfer of risk unless the insured would otherwise be exposed to that risk.)

Note, however, that the test is two-pronged: there must be a legal or equitable relationship, as well as an economic interest. Thus, for example, under English law, an individual cannot insure against being disinherited by his parents; nor can a person take out life assurance on the life of any other person save where he stands to suffer financial loss on that death (the most famous case in this respect involving the courts' refusal to classify as insurance a contract by a subject to insure the life of the King!), in both cases because there is no legal or beneficial interest in the property in question. (Note that it is this requirement of a legal or equitable interest that distinguishes insurance from gambling.)

So whilst it can be seen that the commercial and economic effects of credit derivatives can be similar to contracts of insurance, there is a clear conceptual distinction:

• With a credit default product, the event triggering payment is the occurrence of the credit event and not the loss suffered by the originating party as a result thereof. The existence or otherwise of such a loss is irrelevant to the contract.
• Under the terms of an insurance contract, however, loss to the insured is critical. If the insured has not suffered a loss, the insurer will not be under an obligation to pay.

In the case of a credit default product, although the originating party may suffer a loss if the relevant credit event occurs and, indeed, may have entered into the credit derivative specifically to hedge against that risk of loss, the counterparty is obliged to pay the originating party on the occurrence of the credit event whether or not the originating party has actually suffered a loss.

Why does the difference matter?

The difference is probably of greatest significance in relation to regulation. In the UK, a contract of insurance can only be issued by an authorised insurance company; an insurance contract issued by a non-authorised party will be unenforceable by the issuer and monies paid under it may be recovered by the insured, together with compensation for loss. In addition criminal sanctions are available against the issuer.

Conversely, UK-authorised insurers are prohibited from carrying on any business "other than in connection with or for the purpose of its insurance business" (section 16 ICA). (The intention of section 16 is to ensure that the business of insurance companies is completely ring fenced and isolated from the risks associated with any other commercial activity, whether regulated or not.) Thus a credit derivative issued by an authorised insurer could be unenforceable, and the wrath of the regulator will no doubt be incurred!

In addition, a number of consequences flow from a contract being one of insurance rather than non-insurance and these are, generally speaking, undesirable from a commercial perspective. Two of the most relevant in this context are, first, that insurance premium tax at the rate of 5% is payable on insurance premiums.

Secondly a contract of insurance is a contract of utmost good faith. Whilst all contracts (including derivatives) are subject to considerations of good faith to the extent that the law cannot support fraud, in ordinary commercial contracts, parties are not required to reveal all that they know about the proposed agreement. Subject to certain statutory protections available to purchasers (and in particular consumers), the common law applicable to most commercial contracts is that of "caveat emptor" (let the buyer beware). Not so for insurance.

The "utmost good faith" doctrine means that a duty of full disclosure is imposed on both parties to the contract. In practice, the duty of the insured to give full disclosure is the only one of importance. The duty is onerous - the insured must disclose all material facts which he knows or which he should have known about. The consequence of failure to disclose all material facts is, in English law, also harsh - the insurer can consider the contract void and avoid payment completely.

The consequences of whether a contract is one of insurance or not is also of particular relevance to the securitisation of insurance risk, where care must be taken to structure any note, or insurance-linked derivative, issued as a derivative, as otherwise the note-holders could be held to be carrying on (unauthorised) insurance business as a result of holding the notes.

Thus any person who wishes to write a credit derivative has plenty of reasons to ensure it is not actually a contract of insurance!

How Do Transformer Companies Work?

So, although insurers may wish to write credit derivatives, they may not do so. Bodies (such as banks) which do want to write credit derivatives need to take precautions to ensure the contracts they write cannot be characterised as insurance.

The first of these issues has been addressed by the development of transformer companies.

Although UK insurers cannot write derivative products, they are allowed to enter into insurance policies to insure a counterparty in a derivative agreement. Such a policy would indemnify the counterparty against having to pay losses incurred under the derivative agreement. The transformer effectively places itself in the middle of a structure, enabling the insurer to issue an insurance policy one step removed from the derivative contract.

In a typical transaction, the transformer would write the original swap contract, and the UK authorised insurer would then insure the transformer company, hence avoiding section 16 ICA problems. For the insurer there may also be the opportunity to offset its insurance liability by reinsuring the risk.

Figure 1

In addition, depending on the place of registration of the transformer, it is possible to transform an insurance risk into a derivative contract (i.e. the converse of the above structure - a transformer entering into an insurance policy and then offsetting the risk via a derivative contract). This is possible because in certain jurisdictions (for example, Bermuda) insurance companies are permitted to carry on non-insurance business.

It is also worth noting that although many transformer companies are set up as shells (i.e. with insufficient capital to honour their commitments under the derivative contract without the benefit of the insurance), and it could therefore be argued that the transformer has only a technical (and artificially constructed) liability to pay rather than an actual one, (i.e. casting doubt on the existence of an insurable interest) the inclination of the English courts is to find in favour of an insurable interest whenever the facts allow. Economic effect is not the test applied to the characterisation of a contract.

However (and notwithstanding the above) it is important to observe the legal niceties of the distinction between insurance and derivative contracts and not, in transformer structures, to make the two contracts entered into with the transformer completely "back to back". (The same principles should be observed by parties writing derivatives who desire to avoid the contract being classified as insurance.) The following suggestions may be of use:

(a) the policy should have its own self-contained terms (rather than incorporating and annexing the derivative agreement). In particular, the parties should define and include all the key financial provisions of the insurance within the policy, rather than relying on the derivative contract;

(b) the liability under the policy should not exactly match the insured's liability under the derivative agreement (i.e. there should be a retention of some kind under the policy or some other financial liability for the insured);

(c) where, under a standard ISDA agreement, payment is by instalments with such instalments diminishing if an obligation ceases to be part of the portfolio, be wary of matching this exactly by an identical proportionate premium rebate under the policy;

(d) the benefits of the policy should not be freely assignable, particularly to the originating party.

If the above suggestions are followed, we believe that the risk that a court would characterise the role of a transformer as a mere device, in a structure where the true purpose and intent of the parties is that an insurer writes a credit derivative, would be materially reduced.

This is a grey area of law and it is difficult to state with any certainty where the dividing line between insurance and derivatives is drawn. However, adherence to the above guidelines should result in the relevant contracts, if ever challenged, satisfying the requisite criteria to keep on the right side of the regulators!