Derivatives Collateral Calls Could Affect Life and Annuity Issuers: Moody's

Hedging programs that usually protect life insurers against big changes in stock prices and interest rates could sometimes add stress, by forcing the insurers to add cash, according to analysts at Moody’s Investors Service.

Manoj Jethani and other Moody’s analysts talk about the concern — calls to add collateral for derivatives arrangements — in a look at how the forces that led to the failure of Silicon Valley Bank and Signature Bank, and the effects of those failures, might affect life insurance and annuity issuers.

The big life and annuity issuers that Moody’s rates have plenty of cash, and many sources of “liquidity,” or quick access to more cash, the analysts note. But they suggest that one concern is the possibility that life insurers will have to feed cash into hedging programs.

“The higher interest rate environment has increased collateral posting requirements for companies that have hedge programs in place to protect them from capital movements,” the analysts say. “Just as life insurers run stress tests for lapses in a rising interest rate environment, they also test for liquidity needs related to collateral posting.”

Derivatives Basics

A derivatives contract is an agreement between two parties, or “counterparties,” that requires one party to pay the other if some specified indicator, such as an interest rate benchmark or a stock index, changes.

Counterparties have to provide cash, or evidence that they have quick access to cash, to serve as derivatives collateral, or proof that they can make good on their promises.

U.S. life insurers have about $8.6 trillion in assets. On Dec. 31, 2015, U.S. insurers had posted about $22 billion in derivatives collateral, up from $12 billion a year earlier, according to a National Association of Insurance Commissioners Capital Markets Bureau report that was updated in 2021. Life insurers accounted for 92% of the collateral.

The insurers’ counterparties ended 2015 with $70 billion in posted derivatives collateral, up from $36 billion a year earlier.

In a 2022 report, the Capital Markets Bureau found that 226 of the 763 U.S. life insurance companies tracked had derivatives exposure in 2021.

Regulators’ Perspective

In 2018, when the NAIC’s Liquidity Assessment Subgroup was sketching out a liquidity stress test framework for life insurers, it mentioned derivatives collateral in a stress testing discussion.

“The types of derivatives and their purpose vary widely, but the key liquidity risk is the requirement of daily posting of cash collateral if the fair value of the derivative changes or under other circumstances, such as a credit rating downgrade,” subgroup members observed.

“For example, hedging with derivatives for the risk associated with variable annuity guarantees exposes insurers to liquidity risk, where equity market increases require additional collateral posting by the insurer,” officials added. “Furthermore, during significant equity market declines, counterparties may be challenged to meet collateral calls or payouts on their derivative obligations to the insurer.”

(Photo: Michael Nagle/Bloomberg)