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2013 Year-end Update to the Insurance Industry’s Derivatives Exposure

The insurance industry’s exposure to derivatives — about $38.8 billion, or less than 1% of $5.5 trillion in total cash and invested assets at the end of 2013 — decreased when measured by book/adjusted carrying value (BACV) as reported in the financial statements as of year-end 2013. However, the notional amount of derivatives exposure increased 12% over year-end 2012 to almost $1.9 trillion. The industry reported positions with a positive fair value, where they would receive a payment from the counterparty if the position were unwound, totaling $44.2 billion.  It also reported positions with a negative fair value, where they would owe the counterparty in an unwind, totaling $37.7 billion.  The result is a total net positive position of $5.4 billion. In 2013, property/casualty (P/C) insurers increased the notional amount of their exposure to $122 billion from about $75 billion, while fraternal insurers decreased exposure to $171 million from $276 million. Insurers’ primary use of derivatives for hedging purposes (94% of notional amount held) makes it an important part of an insurer’s investment strategy to monitor. This special report reviews U.S. insurers’ derivatives exposure at year-end 2013. The report highlights shifts in exposure in 2013 and presents comparisons with the industry’s exposure at year-end 2012.

Derivatives exposure and activity are reported in Schedule DB of insurance companies’ quarterly and annual financial statements. In 2010, Schedule DB was revised to be more streamlined and yet provide more detailed information regarding an insurance company’s derivatives exposure and activity. Further enhancements were adopted in August 2012 and were effective for 2013 reporting. Additional changes to reporting requirements are likely to reflect changes in the marketplace and different regulatory needs.

In general, insurance companies use derivative instruments to manage and mitigate a variety of risks. As of year-end 2013, the number of insurer participants in the derivatives market remained at 264, the same level observed at year-end 2012. Among the year-end 2013 participants, 145 were life insurance companies, 101 were P/C insurance companies, 15 were health insurance companies and three were fraternal insurance companies. Title insurance companies had no derivatives exposure in 2013, 2012 or 2011. The 264 participants represent about 5% of the 4,826 insurers filing a 2013 financial statement. In terms of total assets, the 264 participants had total cash and invested assets of $3.5 trillion, or 63% of the $5.5 trillion industry total assets.

Table 1: 2013 Count of Insurers with Derivatives Exposure ($ mil)

Insurance companies with derivatives exposure were domiciled in 45 states, with insurers in New York, Connecticut, Michigan, Minnesota and Massachusetts holding the largest notional amounts. The number of individual derivatives positions across the insurance industry in 2013 fell to about 63,600 from 65,000 in 2012. The average position size was approximately $29.2 million in 2013 compared with an average of $25.4 million in notional value in 2012. The largest single position was a $7.5 billion corridor option held by a life company. A corridor option is an interest rate hedging tool that entitles the holder to receive a coupon at maturity for each day that a specified rate remains within an agreed-upon range. Corridor options are often used by holders with exposure to floating rates because it provides protections from unfavorable rate moves. While providing protection from unfavorable moves, it also limits the benefit of any favorable rate moves.

Table 2: 2013 Count of Insurers with Derivatives Exposure in Top 10 States

Insurance Industry’s Derivatives Exposure

As of year-end 2013, the notional value of derivatives (i.e., options, caps, floors, collars, swaps and forwards reported in Part A of Schedule DB and futures reported in Part B of Schedule DB) held by the insurance industry increased 11.7% to about $1.85 trillion. Options accounted for the largest share (47.2%) of notional value, as discussed in more detail below. At year-end 2012, options represented the second-largest type of derivative held, accounting for a notional value of $669.2 billion (or 40.3% of the derivatives exposure). That was a 36.7% increase from year-end 2011.

Within the insurance industry, life insurance companies are the primary users of derivative instruments. Life companies represented 93.4% of the total notional value outstanding at the end of 2013 (Table 3).The derivatives exposure of life companies in 2013 represented a 9.5% increase from $1.58 trillion of notional value at the end of 2012. P/C companies increased their share of derivatives exposure to 6.6% and also increased their derivatives exposure by 65%, from $75 billion in 2012 to $122 billion in 2013. Health and fraternal insurers accounted for less than 0.06% and 0.01%, respectively, of the overall industry’s derivatives exposure in both years. Fraternal companies reduced their total notional exposure by 38.2% from year-end 2012.

Options were the derivative instrument of choice for insurers in 2013. Options represented a notional value of $875.5 billion (or 47.2% of the insurance industry’s derivatives exposure) as of year-end 2013, a 30.8% increase from year-end 2012. Swaps represented the second-largest type of derivatives held, accounting for a notional value of $867.3 billion (or 46.8% of derivatives exposure), a 4% decrease from year-end 2012. Futures and forwards contributed about $59.8 billion (or 3.2%) and $52.3 billion (or 2.8%), respectively. All derivative contract types except swaps showed year-over-year increases in absolute total notional exposure. The analysis shows 55.8% of the notional exposure in hedging was to hedge against interest rate risk.

Table 3: 2013 Insurance Industry Derivatives Exposure by Derivative Type ($mil)

Although the market typically refers to notional values when referring to derivatives, it does not indicate the true economic exposure that an insurance company might face. For example, in the case of interest rate swaps, the notional value is used only to calculate the exchange of periodic cash flows. The notional value is never exchanged and would be a substantial overstatement of exposure.

Insurance Industry’s Use of Derivatives for Hedging

Insurance companies use derivatives to implement various investment and portfolio strategies, such as hedging, replicating assets and generating income. As illustrated in Table 4, the primary use of derivatives in the insurance industry is hedging, with 94.1% of derivatives exposure at year-end 2013 used for hedging risk. The “other” purpose/strategy category accounted for 4.1% at year-end 2013, followed by replication (i.e., synthetic creation of an otherwise permissible investment) at 1.4% and income generation at 0.4%

As of year-end 2013, the use of derivatives for hedging increased 28% from year-end 2012. Insurers placed increased importance on income generation. As a result of the new emphasis, the use of derivatives for income generation increased 380% to $6.95 billion by year-end 2013, with options being the primary vehicle. Even with the large increase, however, income generation represented less than 1% of the industry’s total derivatives exposure. Replication fell 19%. Derivatives exposure for “other” purposes fell by 29%.

Table 4: 2013 Insurance Industry Derivatives Exposure by Purpose/Strategy ($ mil)

Options and swaps are the primary derivative instruments utilized by insurers to hedge various risks (Table 5). Options accounted for 47.2% of derivatives exposure. Swaps were 46.8% while futures and forwards were 3.2% and 2.8%, respectively.

Table 5: 2013 Insurance Industry Derivatives Exposure by Derivative Type and Purpose/Strategy ($ mil)

Table 6 provides a breakdown of the insurance industry’s exposure to swap derivatives by type of contract and insurance industry type. Interest rate swaps are the most commonly used swap derivative (82.4% of all swaps held by insurance companies), followed by foreign exchange swaps (8.2%) and credit default swaps (4.3%). Similar to overall derivatives exposure, life insurance companies accounted for the overwhelming majority of swap exposure, with a 97.9% share at year-end 2013. Year-over-year, insurers reduced their swap exposure 4%, or $35.8 billion.

Table 6: 2013 Insurance Industry Swaps Exposure by Type of Contract ($ mil)

As Table 7 illustrates, hedging accounted for 96.2% of all swaps derivatives exposure at year-end 2013, and was the primary use for interest rate swaps, currency swaps, total return swaps and “other” swaps. For credit default swaps (CDS), replication was the primary use, with hedging as a secondary use. Total return swaps had the greatest exposure reduction, at about 22%. Interest rate swaps experienced the smallest reduction of exposure, falling only 2%.

Table 7: 2013 Insurance Industry Swaps Exposure by Type of Contract and Purpose/Strategy ($ mil)

Table 8 provides a breakdown of the insurance industry’s options exposure by type of contract and insurance industry type. Put options are the most commonly used (29% of put contracts held by insurance companies). Given the market gains in 2012, insurers likely purchased put options as a hedge against potential declines in market prices. Put options for hedging accounted for 92% of all options transactions. A put option gives the holder the right, but not an obligation, to sell a security at a predetermined price. Caps and calls were 18% and 17% of all option transactions. Similar to overall derivatives exposure, life insurance companies accounted for the overwhelming majority of options exposure, with an 88% share of the industry total at year-end 2013.

Table 8: 2013 Insurance Industry Options Exposure by Type of Contract ($ mil)

Table 9: 2013 Insurance Industry Options Exposure by Type of Contract and Purpose/Strategy ($ mil)

CDS Exposure

As of year-end 2013, the notional value of CDS held by the insurance industry totaled $36.9 billion, a 7% decrease from $39.8 billion in notional value at year-end 2012. Life and P/C companies were the only participants in the CDS market in 2013, as was the case in 2012.

In the CDS market, buying protection refers to reducing credit risk, and selling (or writing) protection refers to assuming credit risk. Buying protection and selling protection are akin to being short and long credit, respectively. Table 8 illustrates that, for year-end 2013, about $27.0 billion (or 73%) of the $36.9 billion in insurance industry CDS exposure was to sell protection (or assume credit risk). The remaining balance was to buy credit risk protection. Credit risk is typically hedged by buying protection on a specific entity or on a specified index. The industry’s bought/sold proportion is 37%, an indication of more positive than negative credit sentiment among insurers.

Table 8: 2013 Insurance Industry CDS Exposure ($ mil)

Hedge Effectiveness

Since 2010, hedges have been classified as either “hedging effective” or “hedging other.” According to Statement of Statutory Accounting Principles (SSAP) No. 86—Accounting for Derivatives and Hedging Activities, a hedge generally is considered highly effective when “the change in fair value of the derivative hedging instrument is within 80% to 125% of the opposite change in fair value of the hedged item attributable to the hedged risk.” A hedge can also be designated as effective “when an R-squared of .80 or higher is achieved when using a regression analysis technique.” Hedge effectiveness must be calculated and documented at the inception of the hedge and then monitored quarterly. It is typically expressed as a percentage. Insurance companies report hedge effectiveness on Schedule DB for each derivative position that is considered an effective hedge. In instances where hedge effectiveness cannot be specifically calculated, insurance companies will disclose the financial or economic impact of the hedge in the footnotes of Schedule DB.

Given the strict criteria and the extensive documentation required, many hedges might not be deemed effective for accounting purposes but still provide strategic value. If a derivative instrument is entered into for hedging purposes, but the transaction does not qualify as an effective hedge as defined above, the hedge would be reported as “hedging other” in Schedule DB. Derivatives in the “hedging other” category still have the intended effect of managing and reducing risk, but simply do not meet the accounting and documentation requirements.

Particularly, according to SSAP No. 86, derivative instruments used in hedging transactions that meet the criteria of a highly effective hedge are valued and reported in a manner that is consistent with the hedged asset or liability (referred to as “hedge accounting”). For instance, if the transaction qualifies as an effective hedge and a financial instrument being hedged is valued and reported at amortized cost on a statutory basis, then the hedging instrument would also be valued and reported at amortized cost. Derivative instruments used in hedging transactions that do not meet or no longer meet the criteria of an effective hedge are accounted for at fair value and the changes in the fair value are recorded as unrealized gains or unrealized losses (referred to as fair value accounting). Therefore, hedge accounting might avoid certain volatility in financial reporting that might be present in fair value accounting.

As of year-end 2013, 94.1% (or $1.7 trillion in notional value) of the insurance industry’s total derivatives exposure was used for hedging purposes (Table 5), slightly lower than the 94.4% observed at year-end 2012. The vast majority (or 93%) of these exposures was categorized as “hedging other” and the remaining balance was classified as “hedging effective” (Table 9). The proportion of hedges classified as hedging effective decreased for a third year to 7%. The proportion was 8% at year-end 2012 and 11.5% at year-end 2011.

Swaps represented $834.6 billion (or 47.8%) of derivatives held for hedging at year-end 2013, a decline from $865 billion (or 55.2%) of the insurance industry’s derivatives held for hedging purposes as of year-end 2012. Both options and forward contracts increased in total notional amount of derivatives held for hedging purposes: options increased to 46% from 33.2% of total notional while forward contracts increased to 2.9% from 2.2% of total notional. Futures, however, remained unchanged at 3.2%.

Table 9: 2013 Insurance Industry Derivatives Exposure for Hedging Purposes by Derivative Type ($ mil)

The insurance industry uses derivatives to hedge various risks. Some examples of risks that are hedged include interest rate risk, credit risk, currency risk and equity-related risk. Insurance companies’ invested assets portfolios are exposed to interest rate risk, as they are large buyers of fixed-income instruments, which are highly sensitive to movements in interest rates. Table 10 illustrates that the most common risk hedged by the insurance industry is interest rate risk. Hedging of interest rate risk as a percentage of total notional value decreased to 55.8% at year-end 2013 from 68.4% at year-end 2012. Much of the interest rate risk hedging might be due to insurance companies’ swapping floating rate payments of instruments into fixed-rate payments to match their fixed-rate liabilities, hedging against falling interest rates, flattening interest rate curve or risk of interest rate spikes. The shifting shape of the yield curve has caused volatility in generally accepted accounting principles (GAAP) quarterly statement gains and losses.

Equity risk is the second-most common risk that the insurance industry hedges with derivatives. At year-end 2013 equity risk was 21.8% of total notional amount hedged versus18.4% of total notional amount hedged in 2012. Insurance companies face equity risk as a result of the sale of certain products, such as variable annuities that offer guaranteed minimum withdrawal or income benefits. Other risks that are hedged with derivative instruments include foreign currency risk and credit risk. Foreign currency hedging is about 18.1% of the total, while credit risk and other is less than 5%.

Table 10: 2013 Insurance Industry Derivatives Exposure for Hedging Purposes by Risk Type ($ mil)

Insurance Industry’s Counterparty Exposure

In a derivatives contract, there are generally two parties involved. Counterparty risk is the risk faced by one party that the other party will not satisfy the obligations of a derivatives contract. Insurance companies face counterparty risk primarily when entering into derivatives contracts that are traded over the counter (OTC), such as options, swaps and forwards. Although futures are traded through exchanges and cleared through a central clearinghouse, counterparty risk still exists but is considered to be small as compared with bilateral counterparty risk.

Table 11 summarizes exposure in notional value to the top 10 counterparties as of year-end 2013. Similar to the derivatives market in general, counterparty exposure in the insurance industry is concentrated in a small number of financial institutions. The 10 counterparties listed in Table 11 represent 71.6% of the notional value outstanding in the insurance industry as of year-end 2013, down from 74.1% in 2012. As noted earlier, notional value does not necessarily indicate the true counterparty exposure that an insurance company might face.

Deutsche Bank lost its two-year position as the largest counterparty to the insurance industry. Citigroup, which held the second position in 2012, is the largest counterparty in 2013, representing 13.2% of the industry’s total notional value outstanding as of year-end 2013. Deutsche Bank is second, at 10.3% of total notional.

Table 11: 2013 Insurance Industry Exposure to Top 10 Counterparties ($ mil)

Note: Counterparty exposure will decrease as more OTC derivatives are moved to a central clearinghouse. Currently, about 8% of OTC derivative transactions are cleared through U.S. Commodities Futures Trading Commission (CFTC)-registered derivative clearing organizations (DCOs).

Analysis of the Insurance Industry’s Posted Collateral for Derivative Transactions

Collateral posting is used to mitigate the risk that a counterparty may not meet all or a portion of its payment obligations under a derivative contract. Prior to 2013, Schedule DB, Part D only reported counterparty exposure for derivative instruments open as of year-end. Beginning with the year-end 2013 filing, a new section (Part D, Section 2) was added to the schedule to include information on collateral posted by the reporting entity and collateral posted to the reporting entity. The new data allows regulators to, among other things, have better insight into the asset types used for collateral. Collateral posted by insurers is measured in BACV; however, collateral posted to insurers is best measured in fair value because, according to the 2013 Annual Statement Instructions, “book/adjusted carrying value does not apply to collateral pledged to a reporting entity in which there has not been a default.”

As of year-end 2013, insurers posted about $14.3 billion BACV of collateral with counterparties and received collateral with a fair value of about $18.5 billion from counterparties. Life companies account for 92% of the total BACV of posted collateral, as they are the primary users of derivatives in the industry. P/C accounted for 8%.

Given their credit quality and liquidity, U.S. Treasury and agency securities are the largest asset types posted as collateral by insurance companies. They comprise 44% of the total BACV of all posted collateral. The next four largest asset types are U.S. corporate bonds (18%), agency mortgage-backed securities (MBS) (17%), cash (9%) and asset-backed securities (ABS) (7%).

Although these assets are pledged as collateral, they remain an asset of the insurer. Any concern with the availability of these highly liquidity assets to regulators in a take-over or wind-down is mitigated by the fact that the posted collateral is a small portion of the BACV of such assets held by insurers. The $8.6 billion of posted collateral is less than 2% of the BACV of U.S. government obligations and agency MBS held by insurers.

Table 12: 2013 BACV of Insurance Industry Posted Collateral ($ mil)

Note: The health insurance industry’s exposure in BACV is approximately $140,000 but is not reflected in the table due to rounding.

About half, or $9.3 billion, of the $18.5 billion collateral posted to insurers consists of cash (U.S. dollar). U.S. Treasuries are 34%, or $6.3 billion, of posted collateral. The remaining collateral consists of agency MBS (8%), U.S. corporate bonds (4%) and foreign government bonds (3%).

Summary

The notional amount of the derivatives exposure remains large and growing, making it an important investment strategy to watch. Life insurance companies continue with the largest derivatives exposure, while title companies remain absent in the use of derivatives. Concern over the size of the exposure is partly mitigated by the focus of the exposure. Rather than income generation, which is more speculative, the focus has mainly been on hedging.

The NAIC Capital Markets Bureau will continue to monitor trends surrounding the derivatives market and its impact on insurance industry investments. We will report on any developments as deemed appropriate.

Questions and comments are always welcomed. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org

The views expressed in this publication do not necessarily represent the views of NAIC, its officers or members. NO WARRANTY IS MADE, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY OPINION OR INFORMATION GIVEN OR MADE IN THIS PUBLICATION.

© 1990 - 2014 National Association of Insurance Commissioners. All rights reserved.

 


Questions and comments are always welcome. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org.

The views expressed in this publication do not necessarily represent the views of NAIC, its officers or members. NO WARRANTY IS MADE, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY OPINION OR INFORMATION GIVEN OR MADE IN THIS PUBLICATION.

© 1990 – 2016 National Association of Insurance Commissioners. All rights reserved.