Applying the new Dodd-Frank Wall Street Reform and Consumer Protection Act derivatives rules to life insurers could limit those insurers’ financial flexibility, a ratings analyst says.

Weigang Bo, an associate analyst at Moody’s Investors Service, New York, looks at the possible effects of Dodd-Frank Act swaps provisions on U.S. life insurers in a new commentary.

The Dodd-Frank Act is supposed to impose new capital, clearing and reporting requirements on swaps transactions, in an effort to keep swaps players from creating financial houses of cards out of regulators’ sight.

Life insurers have argued that they use swaps in a fashion that usually helps reduce systemic risk, rather than increasing it, and that they ought to get an “end user” exemption from swaps requirements aimed mainly at swaps traders and speculators.

The Commodity Futures Trading Commission (CFTC) recently delayed the effective date of the swaps rules to as late as year end, from the original effective date of July 16, and that should give insurers and regulators more time to develop an end user exemption for insurers, Bo writes in the Moody’s commentary.

“US life insurers are big users of swaps to manage their asset/liability risks and to hedge products with long-term guarantees, such as variable annuity products with lifetime income or withdrawal benefits,” Bo says.

Today, Bo says, swaps participants usually do not have to set aside an initial margin, or capital amount, and they must post collateral only when the mark-to-market vale of a transaction reaches a minimum threshold, Bo says. Life insurers and other swaps market participants can use investment-grade bonds and non-agency mortgage-backed securities, which until now have been accepted as eligible collateral.

If the swaps provisions apply to life insurers, life insurers may have to meet new margin requirements and post only cash, U.S. government securities or other highly liquid securities as collateral, Bo says.

The Dodd-Frank rules could require an initial margin ranging from about 0.5% of the swap notional amount for a vanilla 2-year interest rate swap, to more than 10% of the swap notional amount for a 30-year interest rate swap, Bo says.

“The Dodd-Frank rules’ margin requirements would potentially soak up significant amounts of liquidity and create volatility in available liquidity for life insurers if their [over the counter (OTC)] derivatives transactions moved against them,” Bo says. “This would constrain liquidity and financial flexibility for those companies with significant amounts of affected OTC derivatives. We also expect life insurers to hold more liquid assets under the new rules, which would be a drag on investment income.”

At the end of 2010, total notional swaps amounts at 12 large U.S life insurers ranged from $1 billion at one mutual insurer to $138 billion at a large publicly traded insurer, Bo reports.

Other swaps coverage from National Underwriter Life & Health: