The publicly traded U.S. life and annuity issuers are set to start releasing their third-quarter earnings eight days before Halloween: Oct. 23.
Securities analysts are already factoring in impressions of how the issuers have handled low interest rates in general, and how well they have priced and managed old blocks of stand long-term care insurance.
This quarter, another issue could start to fly out of the shadows of the earnings report footnotes and spook investors: How well life and annuity issuers have handled their “hedging programs.” Securities analysts at Morgan Stanley, for example, mention hedging several times in their new third-quarter earnings preview report.
The analysts talk about concerns about dollar-yen exchange rate hedging concerns for Aflac Inc. and Prudential Financial Inc.
The analysts cite variable annuity guarantee hedging costs as an item that could help AXA Equitable report either surprisingly low or surprisingly high third-quarter earnings. The analysts see managing variable annuity guarantee hedging costs as a component of AXA Equitable’s “ability to manage the risk associated with the variable annuity operations while continuing to grow its more profitable group retirement and asset management operations.”
Uh, what is ‘hedging’?
For a life insurer, ‘hedging’ is the use of a contract with another organization to try to reduce or eliminate various types of investment risk.
A life insurer that is protecting annuity holders against drops in interest rates might try, for example, to eliminate its own exposure to drops in interest rates, by paying another financial services company for an arrangement that would pay off if and when interest rates drop sharply. If rates did drop sharply, the life insurer would use cash from the other company to make up for the cost of providing a minimum level of interest for the annuity holders.
A life insurer could use other arrangements to protect against changes in stock prices, or changes in the relative value of the U.S. dollar and other world currencies.
What could make hedging ‘ineffective’?
One challenge, for hedging users, is that, even if the arrangements work exactly as expected, they may compensate the insurer for only part of the change in the value of the hedged item.
If you sell disability insurance, for example, you may have clients who use disability insurance to insure only 60% of their income, with the understanding that they will have to use other mechanisms to compensate for the 40% gap between the insurance benefits and pre-disability income. Insurers, similarly, may use hedging to hedge against only part of the impact of the various types of investment market risk that they face.
A second challenge is that hedging arrangements are complicated. Even if hedges work properly, they may work differently than the life insurers expect.
A third challenge is that the hedging counterparties could fail.