An insurer’s greatest potential exposure is to credit risk, followed by interest rate risk, which together have consistently accounted for over 80% of the potential exposureThe new report from AM Best states that despite the increase in notional value, potential exposure has grown at a lesser rate of 30% during the five-year span, to $67.5 billion in 2020. To access the full copy of this report, please visit here.
OLDWICK, N.J., December 16, 2021—The notional value of insurance industry derivatives, held predominantly by life/annuity insurers, has risen by 45% over the past five years and topped $3.3 trillion in 2020, according to a new AM Best special report.
To support their daily business operations, insurers use a variety of strategies to manage interest rate, foreign currency exchange rate, credit, and equity market risks. Insurers typically use derivatives to minimize risk (hedging), manage risk (portfolio management), or, occasionally, assume risk (speculation). However, the high level of financial market uncertainty, combined with the continued low interest rate environment, have adversely affected hedging costs for products, resulting in higher product pricing.
In hedging and portfolio management, derivatives are used to solve problems or achieve objectives for a portfolio of assets and liabilities. A portfolio manager takes a position to offset an existing or anticipated risk exposure arising from either side of the balance sheet or from the relationship between the two sides. Insurers, for example, can hedge risk exposures resulting from price fluctuations that are incidental to their operations or that arise from changes in exchange rates, by using derivatives to set the price of future purchases and sales.
In their report, AM Best focuses on the notional value and potential exposure of insurers’ derivative programs. The notional value of insurance industry derivatives now tops $3.3 trillion, with 98% held by life/annuity (L/A) insurers. However, they note that although notional values have increased 45% since 2016, total potential exposure has grown only 30%, from $51.8 billion to $67.5 billion in 2020, including a 22% increase last year.
Insurers use derivatives in hedging and portfolio management to set the price of future purchases and sales in order to hedge against price fluctuations. Annuity products account for the largest portion of derivative hedging due to the nature of the products and returns they offer or guarantee. Although derivative use throughout the insurance industry has grown, life/annuity insurers hold 98% of the total notional value.
“Older legacy blocks with higher minimum guaranteed rates, coupled with the low interest rate environment, heighten interest rate risk, which has caused insurers to protect themselves by purchasing more derivatives,” said Brian Keleher, financial analyst, AM Best. As insurers have been reducing minimum guaranteed rates on annuity products over the last decade, they more frequently are hedging against 2-3% rates instead of rates that were offered at 4% and higher before the 2009 financial crisis.
Managing Liability Risk through Hedging
Virtually all (96%) of the industry’s total notional and 58% of derivative potential exposure is related to hedging, while almost all of the remaining potential exposure is used for replication. In a replication transaction, an asset on the balance sheet is paired with a written credit default swap to synthetically replicate a corporate bond, a core asset holding of life insurance companies. This is the key difference between notional value and potential exposure, as credit default swaps purchased for protection report a potential exposure of zero.
Replications are important for managing an organization’s overall corporate credit risk. To match long-dated liabilities, insurers purchase long-dated corporate bonds, but these may not always be readily available, or they may be issued by corporations to which a company may already have significant corporate credit exposure. In addition, the shorter tenor of a credit default swap (generally five years) versus a long-dated corporate bond allows for more flexibility in managing credit exposures.
Derivatives are primarily used to hedge against products in the insurer’s portfolio. Annuity products represented a combined 38.8% of the total notional value: variable annuities (28.7%), fixed annuities (4.1%), fixed indexed annuities (3.5%), and indexed annuities (2.5%). L/A products represented 47% of the total notional value and 18% of the potential exposure. Annuity products account for the largest portion of derivative hedging due to the nature of the products and returns they offer or guarantee.
Derivative Usage Growing Moderately
Roughly 15% of L/A organizations use derivatives, significantly higher than for the P/C and health segments, both of which report less than 2% using derivatives. In terms of notional value, insurers generally have been expanding their use of derivatives for all types of risk, with interest rate and equity/index risk being the two main types subject to hedging. However, an insurer’s greatest potential exposure is to credit risk, followed by interest rate risk, which together have consistently accounted for over 80% of the potential exposure
Derivative use throughout the insurance industry has grown slightly since 2017, while the top ten in terms of notional and potential exposure has seen its share of industry holdings drop. At year-end 2020, the top ten insurers represented 58% of the total notional value (down from 66% in 2017) and 76% of the potential exposure (down from 85% in 2017). Derivative hedging use varies by company, but concentrations in annuity reserves—especially those with minimum guarantee benefit riders—are a driving factor in the decision to use derivatives and in the scale of use. Similarly, the risk profile of the ten largest companies’ derivative use also varies, with some companies having notably stark shifts in the type or scale of risks hedged as their liability profile, interest rate assumptions, and investment environment continue to evolve
Risk Management Remains Priority
Insurers are always subject to the risk that their hedging programs may prove ineffective, or that unexpected policyholder behavior may incur losses or unanticipated spending beyond the scope of their risk management strategies. Hedging counter-parties may fail to meet their obligations, resulting in unhedged exposures and losses on positions that are not collateralized. The cost of the hedging program itself may be greater than anticipated, as adverse market conditions can limit the availability and increase the costs of the hedging instruments that are employed. Such costs might not be recovered in the pricing of the products being hedged.
For example, the cost of hedging guaranteed minimum benefits increases as market volatility increases and/or interest rates decrease, resulting in a decline in net income. As a result, hedging programs should be re- evaluated regularly, to respond to changing market conditions and balance the trade-offs among several factors, including regulatory reserves, regulatory capital management levels, underlying economics, and earnings.
“The cost of hedging guaranteed minimum benefits increases as market volatility increases and/or interest rates decrease, resulting in a decline in net income,” said Jason Hopper, associate director, industry research and analytics. “As a result, hedging programs should be re-evaluated regularly to respond to changing market conditions and other factors.”
AM Best is a global credit rating agency, news publisher and data analytics provider specializing in the insurance industry. Headquartered in the United States, the company does business in over 100 countries with regional offices in London, Amsterdam, Dubai, Hong Kong, Singapore and Mexico City. For more information, visit www.ambest.com.