The starting place for this discussion is that gambling is illegal in New York (unless the bookie is the State itself), and a contract that requires one party to pay the other upon the occurrence of a contingent event is void, gambling debts are unenforceable, and bets must be returned to the bettor. (NY GOL Sec 5-401 et. seq.).

An insurance contract is one which requires the insurer to transfer value to the the insured, upon the occurrence of an event that is beyond the control of either party and which adversely affects an economic interest (“insurable interest”) of the insured. (NY Ins L Sec. 1101 & 3401).

What then distinguishes a void wager from a valid insurance contract? The insurable interest of the insured. If the insured does not have the insurable interest the contract is void and may be unwound at the request of the insurer.

It is illegal to sell insurance without a license, but I do not know if there has ever been a case where illegality was presented as a defense by the insurer. Certainly commercial interest alone would push real insurers away from that claim.

What about option contracts. One answer is that an option is a simple contract of purchase and sale, where the closing and payment are deferred at the option of one of the parties. There is no event that is beyond the control of either party in an option contract. So there is neither an insurance contract, nor a wager.

We can see that economically an option can act as insurance, and, if neither party owns the property subject to the option, it may act as a wager. There has been a great deal of attention to this issue in the chartering of the commodities business and in the swap market.

CDS, depending on the details, might fit into the option paradigm. I think the most important fact would be whether it requires the claimant to tender the defaulted security.

Whatever CDS is, I think the model needs to be rebuilt, if it going to survive. I would go for the exchange traded option route, with the ability to use custom insurance policies by regulated insurers.

The OCC numbers are only for banks under OCC supervision. Among banks, that leaves out the ones subject to OTS and the dwindling number of state-only institutions. More importantly, it leaves out investment banks, hedge funds, mutual funds, foreign banks, and single managed accounts like pension funds and endowments.

I was using industry numbers, but they are likely to be out of date. There is an emergency effort behind the scenes to get things closed or offset, and they may have succeeded to some degree. For example, the night before Lehman filed for bankruptcy, their holders met and tried to trade, offset, or somehow deal with the issue and at least reduce the uncertainty, if not the loss. That effort has continued and probably will for quite some time.

My compliments on a nice piece. I’ve looked for an 8-K from AIG after the auction and haven’t found one disclosing severe losses. If the losses were very large they would have had to have been disclosed per SEC regulation. Are you using ‘trade’ journal references for the $300-$400 billion number? I ask because this OCC report (pages 21 and 26) indicates somewhat less. It certainly doesn’t cover what are called synthetic CDS and that’s where the truly fantastic notional numbers seem to be coming from.

I would also note that ‘insurance’ used as you are doing could also be applied to put options. I tend to think of CDS as out of the money puts. I’m not sure where they belong within the regulatory apparatus but I sure wish the Feds would give them a home – and make the unregistered synthetics unenforceable. Right now it appears that many of these ‘insurance’ policies have been sold to arsonists.

Anyway, watch what happens on Tuesday. If nothing happens, then I’m an uninformed alarmist but a happy one.