Academic journal article Economic Perspectives

Derivatives and Collateral at U.S. Life Insurers

Academic journal article Economic Perspectives

Derivatives and Collateral at U.S. Life Insurers

Article excerpt

Introduction and summary

Insurance companies serve the important economic role of helping businesses and households to insulate themselves against risks. But these risks do not disappear from the economy--they remain on insurers' books, necessitating careful risk management among insurers themselves. Over the past two decades, one way that insurers have managed risk is through the use of derivative contracts, (1) which derive their value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. Some of the more common derivatives include forwards, futures, options, and swaps. Most derivatives, including interest rate swaps (IRS), have historically been traded over the counter (OTC) rather than on centralized exchanges.

The use of derivatives comes with its own set of costs related to the transaction, management, and collateralization of positions. With the implementation of the Dodd-Frank Act of 2010, those costs seem certain to rise. Among other provisions, the law requires the central clearing of certain types of OTC derivatives and mandates that those transactions must satisfy margin requirements that will in most cases require counterparties to post more collateral than was previously the case. (2) Forthcoming rules will impose additional collateral requirements on derivatives positions for which the central clearing mandate does not apply. Thus, the new rules for both cleared and noncleared derivatives could generate new costs for insurers or require changes in their business practices.

In this article, we review life insurers' use of OTC derivatives and discuss the possible implications of these new rules for their financial condition. (3) Although insurers represent a relatively small part of the derivatives markets, they are an interesting case study, in part because they report very detailed information about their derivatives positions and associated collateral in quarterly regulatory filings. We exploit these data to study how derivatives are used by insurers and to get a quantitative sense of what the new regulations are likely to imply for their business models.

The new regime poses several potential costs for insurers. For example, like many market participants, insurers will face a short-term fixed cost of adjusting operations and corporate structure to meet the new clearing and collateralization requirements, as well as ongoing expenses associated with trading, collateral optimization, and back-office functions; and insurers may also face some regulatory capital consequences.

In this article, however, we focus on one particular set of costs that has received attention, namely, costs related to reallocating insurers' portfolios to highquality--and therefore low-yielding--assets in order to meet margin requirements. (4) We find that, overall, the requirements are unlikely to generate large costs for the industry as a whole through this channel-although there are some low-probability tail scenarios in which they could result in substantial forgone investment income for a few larger insurers. This finding is largely due to the fact that insurance companies already hold large amounts of high-quality unencumbered securities that could be pledged for this purpose, and indeed they may be natural collateral providers to other market participants. (5)

After reviewing insurers' use of derivatives and collateral in the following section, we develop a Monte Carlo exercise to attempt to quantify the amount of margin posted and revenue lost due to required margin under different scenarios for interest rates and insurer portfolio evolution. Then, we consider some ways that insurers may adjust their business practices in light of the new regulations. Two likely responses are to reduce the need for hedging by shifting more interest rate risk onto consumers or markets and to build up new sources of liquidity to cover cash needs. …

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