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.