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Dodd-Frank Swaps: Insurers Eye "Substantial Position" Definition

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The U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) cite insurer comments several times in a draft that would implement part of the swaps provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Commissioners at the SEC and the CFTC last week agreed to seek comments on a swaps definitions proposed rule, which would help define terms such as “swap dealer,” “security-based swap dealer,” and “major swap participant.”

In the Dodd-Frank Act, Congress has defined a swap as any agreement Dodd-Frank compassthat is a “put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind.”

The exact definition of terms such as “major swap participant” could determine what new swaps rules apply to life insurers; whether life insurers or their affiliates must conduct some, or any, swaps transactions through clearinghouses or exchanges; and whether life insurers will find themselves interacting more with the CFTC.

The SEC and the CFTC put out a joint notice about the swaps definitions rulemaking effort in August, and they received about 80 comments. The new proposed rule is set to appear in the Federal Register soon.

Under Dodd-Frank, a swaps market participant with a “substantial position” is supposed to get extra attention from regulators.

Some commenters told the SEC and the CFTC that regulators should define “substantial position” by using a test based on the current, uncollateralized mark-to-market swaps exposure, officials at the commissions say in a preamble to the proposed rule.

Some commenters suggested setting specific dollar amountas as the threshold.

Jennifer Kalb of MetLife Inc., New York (NYSE:MET), wrote

to suggest that swaps positions subject oversight by a central clearinghouse should be excluded from any substantial position test.

“After considering these alternatives, the Commissions are proposing two tests to define ‘substantial position.’” officials say. “One test would focus exclusively on an entity’s current uncollateralized exposure; the other would supplement a current uncollateralized exposure measure with an additional measure that estimates potential future exposure. A position that satisfies either test would be a ‘substantial position.’”

The SEC and the CFTC are asking for ideas about tests that could be used as alternatives or supplements to the two tests.

The first test, for current uncollateralized exposure, would reflect Dodd-Frank Act language by excluding positions held for “hedging or mitigating commercial risk,” officials say.

Kalb said the use of the word “mitigating” in the act “plainly indicates that this exclusion intends an expansive definition of hedging and can also encompass non-speculative derivatives positions used to manage economic risk, including potentially diversification and synthetic asset strategies, such as the conservative ‘replication’ strategy permitted under state insurance laws.”

The SEC and the CFTC note that the Dodd-Frank Act uses similar language in a section that lets non-financial entities avoid the new mandatory swaps clearing requirement if those entities are using swaps or security-based swaps to manage commercial risk.

Because Congress used similar language in both instances, the commissions interpret the language in the same manner, officials say.

But officials say they will be a little more generous to financial entities in the “major participant” definitions. When trying to avoid being classified as a major participant, a financial entity can keep swaps used to hedge or mitigate commercial risk out of position calculations officials say.

Still another Dodd-Frank provision would let regulators classify a swap participant as a “major” participant if the participant appears to be “highly leveraged.”

Steve Martinie of Northwestern Mutual Life Insurance Company, Milwaukee, and other commenters suggested that regulators should assess whether a swap participant is highly leveraged by comparing companies to other companies in the same industry, rather than applying a universal leverage measure. .

Martinie suggested that financial firms require less cushion than other entities because financial firms are able to match their assets and liabilities more closely, officials say in the draft preamble.

Martinie also suggested that the SEC and the CFTCrecognize that liabilities such as bank deposits and insurance policy reserves are not leverage, officials say.

The SEC and the CFTC ended up deciding that an entity would be considered “highly leveraged” if the ratio of its total liabilities to equity is in excess of 8 to 1, or if the ratio of the entity’s total liabilities to equity is in excess of 15 to 1.