A. Life insurers use a variety of financial arrangements, such as exchange-traded futures contracts, and over-the-counter swaps and options, to “hedge themselves” against swings in interest rate and investment price risk.
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 four 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.
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.