Derivatives lawyers and professionals are starting to marshal their defense against a recent National Association of Insurance Commissioners' white paper which recommends that insurance companies should be the sole provider of weather derivatives. Derivatives practitioners fear the same arguments could be used to rule that credit derivatives should also become the exclusive preserve of insurance companies. Credit derivatives were singled out because credit insurance pre-dated the instruments and a lot of protection buyers are using the derivatives to protect against loss rather than to speculate. NAIC papers are usually accepted by U.S. state regulators and if this one is it will become law. Roger Hoadley, spokesman at the NAIC in Kansas City, Mo., did not return calls.
William Latza, partner at Stroock & Stroock & Lavan in New York, noted that this is a departure for the NAIC, which has traditionally favored capital market participation in risk transfer. The International Swaps and Derivatives Association recently sent out an e-mail detailing the problem to its Tax Credit Derivatives Working Group.
The insurance versus derivatives argument is critical to derivatives houses because they are not allowed to write insurance contracts. In the early stages of the credit derivatives markets ISDA commissioned U.K. barrister Robin Potts to write an opinion on whether default swaps should be classified as insurance. Potts opined that they are derivatives because the protection buyer does not need to suffer a loss in order to receive a payout. Patrick Clancy, counsel at Shearman & Sterling in London, said the NAIC's paper has skimmed over this point.
Several U.K.-based lawyers do not think the NAIC's arguments will convince the Financial Services Authority, the regulator for banks and insurance companies, that weather or other derivatives should be an insurance product. Weather derivatives are fundamentally different from other types of derivatives because they are not based on an underlying capital market.
Last year the over-the-counter derivatives market came under fire from the investment community and accounting regulators because of the amount of speculation, leverage and off-balance sheet structures they allow. So bankers were furious at the NAIC for criticizing the risk management role of derivatives. One said, "We are an easy target right now." Shearman & Sterling's Clancy added, "If you are [choosing to] regulate weather derivatives when they are a hedge against loss, but you don't legislate against them when they are speculation, maybe you are [making the wrong choice]."
Bankers are, however, already aware that some highly structured illiquid credit derivatives could fall the wrong side of the divide (DW, 6/1).
