New derivatives regulations that kicked in this month will be costly for U.S. life insurers, requiring between $10 billion to $30 billion of additional collateral and liquidity needs over time for the top 20 U.S. life insurers, according to a new report from Moody’s Investors Service.
Life insurers are major users of derivatives, which are used, among other things, to hedge interest rate risk and variable annuity (VA) portfolios. They are heavy users of interest rate swaps in particular.
So when new derivative regulations under Title VII of the Dodd-Frank Act went into effect June 10, U.S. life insurers, among other “financial end-users,” are now required to not only trade and clear their interest rate swaps on registered exchanges or clearing houses, but to post larger sums of higher quality collateral, said the report, written by Laura Bazer, Moody’s senior credit officer.
As of year-end 2012, interest rate swaps accounted for approximately $957 billion, or an estimated 60 percent of the total $1.6 trillion of onshore notional derivative exposure of the top 20 U.S. life insurers, according to Moody's.
Life insurers liquidity needs will rise with the collateral needs, judging from the top 20 life insurers. The 20 companies, largely led by MetLife in terms of their total interest rate derivatives outstanding-notional amounts, had a total of almost $1 trillion ($957 billion) in interest rate swaps outstanding at year-end 2012, or an estimated 60 percent of the total $1.6 trillion of onshore notional derivative exposure of the top 20 U.S. life insurer, Moody’s stated.
One percent to three percent of notional value would translate into approximately $10 to $30 billion in additional collateral needs over time as the outstanding derivatives expire, assuming the companies need to replace all of them to keep their products properly hedged, Moody’s Bazer calculated.
Bazer used a five-year interest rate swap as an example, concluding that life insurers could have to post an additional one percent to three percent of the notional value of their new derivative contracts, with as much as 10 percent of notional for long-dated (for example 30-year) or complex contracts.
She said that these calculations could even under-estimate the actual amount of liquidity ultimately needed by life insurers because of the additional need to continue to post “variation margin” collateral and the higher collateral needs of longer-dated/more complex swaps. Bazer added that the existence of sizable additional derivative portfolios in force in offshore locations, are likely to be affected by the new rules, but were not reviewed in her analysis.
Also, pointing toward future added “pain,” Bazer pointed to the fact that U.S. regulators continue to develop and implement derivative regulations with an eye to aligning U.S. regulations more closely with reforms planned for implementation in other major markets outside the United States. She cited the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities's (IOSCO) consultative paper on margin requirements for uncleared derivatives (like OTC derivatives), establishing minimum standards to be phased in from 2015 to 2019.
MetLife has addressed these issues, it says. Specifically, the company is merging subsidiaries and onshoring its variable annuity risks.
MetLife announced in May at its investor conference that it is taking three major companies and merging them to create a larger U.S.-based statutory entity that includes MetLife Insurance Company of Connecticut, MetLife Investors USA (Delaware) and MetLife USA, which has been the primary writer of its variable annuity risk in the past few years. It is also including MetLife Investors Insurance Co. of Missouri, which has some VA risks. It is also exiting its reinsurance company, which is a variable annuity reinsurer.
“The VA risk was concentrated in a reinsurance company that mainly had only derivatives as its assets to manage that risk. It didn’t have a lot of other assets there to post this collateral for derivatives," MetLife CEO Steve Kandarian said in the investor presentation.
He discussed the new margins coming into place, new requirements for initial margins for derivatives, which began this month, that will be phased in over these coming years, under Dodd-Frank as well as the international bodies' suggestions that will be phased in over a longer period of time. Moody's called the reorganization a credit positive.
However, “all derivatives as of June 30 of this year are grandfathered, so you don't need to post the initial margin as you have to buy new derivatives and we have longtail derivatives, so it will affect us over many years,” Kandarian explained in May.
Kandarian spoke of the regulations requiring collateral to be posted for initial margins but said that by bringing these derivatives into a large statutory capitalized insurance company in the United States with a lot of assets, “the collateral is not really an issue. If we have left it in the offshore reinsurance company, we would have to find cash from the holding company to match that initial margin,” he said.
Bazer acknowledged in her report that the grandfathering of existing derivative positions and the gradual turnover of derivative portfolios mitigate the earnings effect of the new rules somewhat, and that is likely also helping MetLife.
Moody’s also sees some positives in these developments. First, individual counter-party risk will fall as exchange-based trading provides greater protection for participants. Second, Moody’s states that higher quality asset holdings is a good thing.
“That life insurers will have to hold more high-quality assets to post as eligible collateral for their derivative positions is positive for the credit profile and liquidity of their investment portfolios. Replacing higher-risk assets, which have a higher capital charge under statutory accounting, for government securities should also free up capital, improving capital adequacy, as measured by the NAIC Risk-Based Capital (RBC) ratio,” Bazer concluded in her report.
Courtesy of Moody's: