A life insurer is asking federal financial services regulators to revise a proposed regulation that could sharply restrict the types of assets it could use to meet margin requirements.
Representatives from Principal Life Insurance Company, a unit of Principal Financial Group Inc., Des Moines, Iowa (NYSE:PFG), made that argument earlier this month in a meeting with officials from the U.S. Commodity Futures Trading Commission (CFTC) and also in a comment letter submitted the CFTC and other federal agencies in August.
A swap is an arrangement that one party can use to trade an income stream with another party. Investors, speculators and others use swaps to manage risk from variations in, or speculate on, changes in, interest rates, exchange rates and the likelihood that debtors will default on their obligations.
The CFTC and the U.S. Securities and Exchange Commission are in the process of implementing provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that call for the agencies to work together to create a swap market regulation system.
Many swaps would be cleared by clearinghouses and face relatively light federal regulation. Other uncleared, over-the-counter (OTC) swaps would face heavier regulation.
The agencies are dealing with matters such as “initial margin requirements,” or the amount of collateral that a company must post when setting up an OTC swap arrangement, and “variation margin requirements,” or the amount of additional collateral a company must post when the market moves against the company.
The SEC and CFTC want the life insurers and other companies using OTC swaps to use high-quality, liquid assets, to help guard against the kind of liquidity crisis and credit market freeze that started in 2007.
Julia Lawler, Principal’s chief investment officer, says in the August comment letter that the current proposal is too rigid.
Principal Life uses swaps to try to reduce the risks associated with assets that back life insurance policies, annuities and other products that often have long durations, Lawler says.
Because of the long-term nature of the assets and liabilities, and because of the accounting rules that govern the life insurance business, “the vast majority of Principal Life’s derivatives transactions are over-the-counter … bilaterally negotiated transactions with highly rated counterparties,” Lawler says.
Principal Life expects to be classified as a low-risk financial end user, and, because its counterparties are high-quality, it does not normally post or collect initial margin on OTC derivatives trades, Lawler says.
The new margin requirements would increase Principal Life’s costs by significantly increasing the amount of collateral needed for OTC trades and therefore increase the cost of the company’s hedging activities, Lawler says.
Lawler notes that one provision would limit Principal Life to using cash, U.S. Treasuries or government agency debt for initial margin amounts.
For variation margins, the company could use only cash or U.S. Treasuries.
Today, the company can also use high-quality corporate bonds and high-quality, liquid mortgage-backed securities (MBS).
For Principal Life, being able to use corporate bonds and MBS is helpful, because, as an investor that invests mainly in fixed-income instruments, Principal Life invests heavily in those types of assets, Lawler says.
“We believe it is possible to develop criteria that satisfy the regulators’ concerns, yet permit financial end users to post highly liquid and high quality MBS as eligible collateral for initial and variation margins,” Lawler says.
But the current industry practice of bilateral support arrangements helps insurers manage risk, and insurers should still be able to ask dealer counterparties for collateral, Lawler says.
Otherwise, the SEC and CFTC could sharply limit low-risk financial services companies’ ability to use their cash at a time when federal agencies are trying to get banks and other companies to help the economy by spending their large and growing pools of cash, Lawler says.
The rules also should be set up in such a way that swap users have to liquidate collateral to meet margin calls only when counterparties actually default, not just to respond to margin changes, Lawler says.