In the Best’s Special Report, “Notional Value of Derivatives Exceeds $3 Trillion,” 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. 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.
According to the report, a significant portion of potential exposure is used for replications, which are important for managing an organization’s overall corporate credit risk. 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 represents the key difference between notional value and potential exposure, as credit default swaps purchased for protection report a potential exposure of zero.
“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.
The report also notes that insurers are subject to the risk that their hedging programs may prove ineffective, or lead to unexpected consequences. “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.”
