A Random Walk Down Wall Street (2015 11 ed, but an 2019 ed. is upcoming). p. 100 Top.

  To make matters even more complicated, there was not just one bond issued against a package of mortgages. The mortgage-backed securities were sliced into different “tranches,” each tranche with different claim priority against payments from the underlying mortgages and each with a different bond rating. It was called “financial engineering.” Even if the underlying mortgage loans were of low quality, the bond-rating agencies were happy to bestow an AAA rating on the bond tranches with the first claims on the payments of interest and principal from the underlying mortgages. The system should more accurately be called “financial alchemy,” and the alchemy was employed not only with mortgages but with all sorts of underlying instruments, such as credit card loans and automobile loans. These derivative securities were in turn sold all over the world.
  It gets even murkier. Second-order derivatives were sold on the derivative mortgage-backed bonds. Credit-default swaps were issued as insurance policies on the mortgage-backed bonds. Briefly, the swap market allowed two parties—called counterparties—to bet for or against the performance of the mortgage bonds, or the bonds of any other issuer. For example, suppose I hold bonds issued by General Electric and I begin to worry about GE’s creditworthiness. I could buy and hold an insurance policy from a company like AIG (the biggest issuer of credit default swaps) that would pay me if GE defaulted. The problems with this market lay in the fact that the issuers of the insurance such as AIG had inadequate reserves to pay the claims if trouble occurred. And anyone from any country could buy the insurance, even without owning the underlying bonds. [I bolded.] Eventually, the credit-default swaps trading in the market grew to as much as ten times the value of the underlying bonds, pushed by demand from institutions around the world. This change, where the derivative markets grew to a large multiple of the underlying markets, was a crucial feature of the new finance system. It made the world’s financial system very much riskier and much more interconnected.

Please see the bolded sentence and the titled question. I believe that personal life insurance requires the beneficiary to be related to the insured. Why not for credit-default swaps?


1 Answer 1


In a free market, two parties should be free to contract/trade whatever they like, under whatever conditions they like, unless the state has good reasons -- be it economic, moral, religious, or otherwise -- for intervening.

So I would instead rephrase your question as the following two questions:

Question 1. Why is it that in life insurance, the state intervenes by imposing the requirement known as insurable interest?

Question 2. Are there good reasons for the state to likewise impose a similar requirement on credit default swaps (CDS)?

Question 1. Actually, during the early (modern) history of insurance (which involved primarily life and marine insurance), you could buy insurance even without having an underlying stake in the insured object or what we now call an insurable interest.

As you can imagine, this led to a number of abuses, including murders and ships getting lost or destroyed. The term moral hazard actually originated in this context (and has since been appropriated by economists to mean something slightly different).

One result of such abuses was that in 1746, the Marine Insurance Act came into effect in Great Britain and introduced the doctrine of insurable interest:

WHEREAS it hath been found by Experience, that the making Assurances, Interest or no Interest, or without further Proof of Interest than the Policy, hath been productive of many pernicious Practices, whereby great Numbers of Ships, with their Cargoes, have either been fraudulently lost and destroyed ... no Assurance or Assurances shall be made ... without further Proof or Interest than the Policy, or by way of Gaming or Wagering, or without Benefit of Salvage to the Assurer ...

Question 2. With CDS, the arguments in favor of imposing the insurable interest doctrine are weaker. For example, the risk of moral hazard is lower, because it is harder to cause a firm or sovereign state to default than to murder someone or burn a ship.

So by and large, CDS are treated by most governments as being just like any speculative asset that anyone is free to trade in at one's own risk.

Nonetheless, Germany (2010) and the EU (2012) have imposed this doctrine on CDS, though only for debt issued by European governments and not by firms -- see e.g. Aldasoro and Ehlers (2018).

Some of the blame for the Global Financial Crisis has been rightly ascribed to CDS. However, I think the two big problems with CDS were the lack of transparency and the systemic risk (or "domino effect"), rather than the lack of an insurable interest requirement.

Imposing the insurable interest requirement would not have much mitigated these two problems, except perhaps by increasing the transaction costs associated with CDS and thus decreasing their use.


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