Let’s take a short break from “all credit crisis, all the time.” I want to talk about an issue that troubles us in a number of ways. The legal doctrine of “insurable interest” [II] is critical to the life insurance industry. II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person. The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.
This protection exists for several reasons:
- Insurance exists to reduce risk, not promote gambling.
- The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured. Absent that, the IRS will eliminate those favors.
- We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person. Even though murder by the policyholder would invalidate the claim, that can be hard to catch.
Now, those who know me as a life actuary know where I am going next. I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like. Good guess; I’ve written about those before. I’ve turned down job offers in that area for ethical reasons. You only get one reputation in the business, so you better guard it carefully.
But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed. I’m going to write about credit default swaps.
Wait. What do credit default swaps have to do with insurable interest? Legally, nothing at present. This article will suggest that there should be a link.
Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm. Corporations are corporate persons under the legal code. Should they not get the same protection?
Credit default swaps pay off when a corporation “dies.” I know there are additional complexities here, but play along with me for now. There are parties that get hurt when a corporation dies:
- Sponsored pension funds
- Debt/loan holders
- And maybe more…
They have an insurable interest in the continued well-being of the corporation. They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more. Any excess exposure is gambling, not insurance, and should be forbidden by law.
Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds. Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.
Now, if you see my logic, forward this article to your Senators and Congressmen. Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.
At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.