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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.

Resources

  • 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.

Kyal Berends and Thomas King, for example, wrote a paper in 2015 that was published by the Federal Reserve Bank of Chicago.

The Fed econonomists noted that, in 2014, U.S. life insurers accounted for a relatively small share of the total derivatives market.

The economists wrote that over-the-counter derivatives contracts have been regarded as being riskier than arrangements made through an exchange, and that life insurers had about $1.1 trillion in exposure to over-the-counter derivatives.

Now big life insurers, including TIAA-CREF and Northwestern Mutual, had to little exposure to derivatives to show up in a derivatives exposure table.

4. The typical counterparty for a life insurance company derivatives arrangement is a financial services giant.

According to the NAIC Capital Markets Bureau report on insurers’ 2018 derivatives use, the 10 largest sources of U.S. life insurers’ counterparty exposure accounted for about 49% of the exposure, and they are well-known companies.

The four biggest, which account for 31% of the exposure, are J.P. Morgan Chase, Barclays Bank PLC, Bank of America Merrill Lync, and AIG Financial Products.

5. At this point, what’s really happening to life insurers’ level of counterparty risk appears to be murky.

James Hyerczyk, a trader and technical analyst, wrote in a blog entry for FX Empire that, apparently, the debt markets were close enough to “the brink of collapse” to “cause the Fed to take aggressive action.”

Analysts at J.P. Morgan Asset Management wrote, in an article aimed at bond investors, that flows of cash “have dried up, not only in equities and high-yield credit, but also in high quality credit funds… Liquidity has also become challenged, as primary markets have essentially shut down, and secondary markets are demanding a higher price for liquidity.”

But rating agencies seem to be assuming that the hedging arrangement counterparties will make good on their obligations.

In February, for example, analysts at Fitching Ratings wrote that, “Many, if not all, insurers that sold variable annuities with living benefits have hedged their market risk or interest rate risk or both in some fashion…. Insurers with more effective hedging programs are expected to weather the disruption better than insurers with ineffective programs.”

Today, Fitch changed its overall rating outlook for U.S. life insurers to negative because of all of the turmoil.

Fitch said in the announcement of the outlook change that its analysts have concerns about falling stock prices and interest rates, and the potential for a sustained disruption in the broader economy.

A disruption in the broader economy could “cause deteriorating in the credit markets, which could lead to increased bond and loan defaults and further pressure statutory capital levels,” the analysts wrote.

But the analysts also said that U.S. life insurers have very strong capitalization levels, good asset quality and very strong liquidity, and they did not even mention the possibility of counterparty risk being a concern.

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