For life insurance agents, watching life insurers go on a wild market rollercoaster, one logical question might be, “So, how are the bolts on the seatbelts doing?”
Life insurers use a variety of financial arrangements, such as exchange-traded futures contracts, and over-the-counter swaps and options, to “hedge themselves” — or buffer themselves — against swings in interest rate and investment price risk.
- A list of NAIC Capital Markets special reports is available here.
- A copy of the Financial Stability Oversight Council 2019 annual report is available here.
- A copy of a paper by Federal Reserve Bank of Chicago economists on derivatives and collateral at U.S. life insurers is available here.
- An article about the current situation is available here.
In theory, when markets jump up and down, the hedging arrangements are supposed to limit any damage to the effect of plunging interest rates on bond-related portfolio yields, and they’re supposed to limit damage to customers who have life or annuity account value tied to the value of investment indexes, along with minimum product performance guarantees.
One question for life insurers risk managers is wondering whether they picked the right hedging strategies.
Another question is how well the other players involved in the hedging arrangements, or “counterparties,” will meet their obligations.
Here are five more things to know about life insurers’ hedging arrangements.
1. The financial hedging arrangements are just part of life insurers’ defenses against market swings.
Life insurers may try to offset the performance of products that will do poorly when the stock market falls, for example, by selling other products that may do well when the market falls.
They also include many provisions in product contracts that limit the consumers’ ability to withdraw assets quickly.
Those restrictions may protect consumers from cashing out valuable insurance protection or income planning products too quickly, and they may protect the issuers’ from “runs on the insurance company,” or situations in which consumers might rush to the insurance company to pull cash out.
2. The National Association of Insurance Commissioners (NAIC) helps state insurance regulators keep close tabs on life insurers’ hedging.
The NAIC’s Capital Markets Bureau compiles voluminous data on hedging, and it publishes annual summary reports every year.
The latest report, for example, shows that, at the end of 2018, 219 of the 722 U.S. life insurers that the NAIC was tracking had financial derivatives exposure with about $2.5 trillion in notional value.
About $1.2 trillion of the exposure involved swaps, or agreements to trade the liability for one financal instrument with the liability for another financial instrument.
About $1.1 trillion of the exposure was associated with options, or arrangements that lock in the insurer’s ability to make a transaction at a particular price. An S&P 500 index option, for example, may help a life insurer support a life insurance policy or annuity contract with an investment option tied to the performance of the S&P 500 index.
3. The federal Financial Stability Oversight Council and economists in the Federal Reserve system also track life insurers’ hedging risk.
Life insurers seem to have come into this period in a strong finanancial position, according to FSOC.
“Overall, the life sector has managed to consistently operate with positive profits and growth in equity for each of the past 10 years,” according to FSOC.
Economists at the Fed, who generally are writing papers that express their own opinions, not the views of the Fed, have tended to be more skeptical about life insurers’ finances.