New York is holding public hearings on its intention to regulate the Credit Derivative Swaps market that helped create our financial crisis.
Today, in an effort to show it's everyone's business, how did this financial instrument help cause problems for big insurers like AIG?
There is no claim here to be an expert on credit derivative swaps. They are considered as one example of the many things we consumers don't know about that perhaps we SHOULD know about because they amount to a risk being taken by institutions, including insurance companies like AIG that leave everyday consumers holding the bag.
A credit default swap is a CONTRACT between two (company) parties. One entity pays PREMIUMS to another company that COLLECTS PREMIUMS (such as a hedge fund or bank). A third company is called the REFERENCE ENTITY. So the credit default swap is like an insurance contract taken out on the Reference Entity that will allow the premium payer to collect "insurance" from the premium receiver IF the reference entity suffers a credit event. A credit event usually includes a reference entity experiencing bankruptcy, a restructuring or a failure to pay.
These credit events that trigger the obligation of the premium receiver to pay the premium payer are Caused by the reference entity which has issued its own bonds. The bonds, like bonds from the US government, allow people to receive interest by leaving their money with the company for a set period of time and to receive interest payments.
If a financial credit event occurs the premium payer wants to collect on the "insurance" he has purchased. The premium receiver has to pay on the "policy".
But a few things went on in this industry. First, companies that were premium receivers took premiums from people WITHOUT THE ABILITY TO PAY IF A CREDIT EVENT OCCURRED. The policies were junk because the liabilities (the potential of what the premium receiver owed was greater than the money they had). If the premium receiver declares bankruptcy, the premium payers lose the money they paid in, further, the financial institutions that were premium receivers also go belly up (AIG) and that is reflective of the basic problems of the reference entity (the company that everyone was betting on). So entities paying premiums figured that even if the reference company went bad they'd collect their money, entities receiving premiums figure'd they'd never have to pay so they didn't keep cash on hand to pay, and the reference entities suffered financial losses or issues that caused the triggering event to begin with.
So why is NY trying to regulate the credit derivative swap like insurance? Because insurance companies are subject to rules, especially those regarding having enough money to pay out on their "policies". And why is this relevant for consumers?
As consumers of health insurance policies we KNOW that protection under that policy depends on the company's sticking to its end of the deal. In health insurance, that deal has been eroded at the basic level of contract description. Whether limitations from raising premiums and deductibles and copayments or changes to participants and coverages of medications, we rely on the company at least being there when we need to collect on our policies. But as we compete and scramble to get a policy, we've omitted the fact that insurance companies lost money as INVESTORS. Like governments that can't make ends meet and raise taxes, insurers raise premiums, mandating that the consumer cover their bad decisions or risky behavior.
NY is asking the federal government to follow its lead in regulating the credit default swap market. As consumers, our knowledge of "insurance" also leads us to seek legislation that prohibits the use of consumer dollars by insurance companies for other than operating expenses of the company and paying for actual medical services for insureds. Requirements in the form of legislative mandates must consider how much of our premium dollars must go to paying for needed medical services. Bad investments by insurance companies should not be made up by "taxing" consumers in the form of increased premiums or less coverage. Without such steps, it is amazing that anyone would consider a long term care "contract" with a company that they can only HOPE will not alter their agreement, or disappear by the time they need to "collect."
The insurance industry whether it is the traditional insurance industry or this credit default swap makes money in a direct relation to how much it pays out. Pay out less and earn more. It's that simple. Today, as consumers, we see the stark consequences of companies that agreed to "insure" and did not have enough cash to pay out on that "insurance." So do we really have to worry about our insurance companies going under and our complete loss of premium value and coverage?
Look at Medicare. Those of us who have paid in for a lifetime will probably receive far less if anything than those who came before us. And how about those long term care policies? We're often told not to worry because most states have a "guaranty association or fund" that kicks in like the FDIC for bank failures. But, as we know from the recent bank failures, there are limits on what you can recover. For many kinds of insurance (property, casualty, life) the limit of the state guarantee is $300,000.
So today, Keep it simple, support legislation to regulate the credit derivative swap like insurance and support MORE regulation of the insurance industry.
