Derivatives

Last Updated 9/14/17

Issue: Derivatives are contracts between two parties that derive their value by creating pure price exposure to an underlying asset, rate, index or event. Derivatives play a central role in hedging and managing risks and as such can help promote stability in the financial markets. On the other hand, the use of derivatives primarily for speculation can potentially pose a threat to both the financial market and the economy as a whole.

Overview: Insurance companies use derivative instruments to manage and mitigate a variety of risks. As of year-end 2015, 208 insurance companies—only 5% of all active insurance companies nationwide—have derivatives exposure, but those involved with derivatives tend to be larger, accounting for $3.68 trillion, or 63% of total insurance industry assets. In the life segment, derivatives use is concentrated among just 136 companies that together account for $3.29 trillion in assets, or 87% of the segment total. In all other segments, fewer than 5% of insurers use derivatives, although the two fraternal companies with derivatives positions account for 45% of segment assets, and the 64 P/C companies using derivatives account for 19% of that sector's assets.

Total industry derivatives exposure in BACV terms as of year-end 2015, totaled $55 billion, accounting for just less than 1% of total cash and invested assets, and representing a decrease of 4% from year-end 2014. The total notional decreased 0.5% from year-end 2014, to $2 trillion. From year-end 2010, through year-end 2015, total insurance industry exposure in BACV terms grew 168%, for a compound average growth rate (CAGR) of 21.8%, while the total notional increased 86% (13.3% CAGR)..

Insurers use a variety of hedging tools. To hedge interest rate risk, as of year-end 2015, insurers tended to favor interest rate swaps (64% of total interest rate risk hedges' notional value) and options (34%), including interest rate caps (21%), as well as other vehicles such as floors and swaptions. To hedge equity risk, the primary tools were put options (40%), call options (32%) and collars (11%). FX risk was hedged mainly with currency swaps (63%) and forwards (26%), and credit risk was hedged mainly with credit default swaps (CDS) (87%), as well as a smaller number of total return swaps.

Interest rate swaps are the most common (83% of notional value for all open insurance industry swap positions), followed by FX swaps (8%), total return swaps (4%) and CDS (3%). Similar to overall derivatives exposure, life companies accounted for the vast majority of swap exposure within the insurance industry, with a 98% share at year-end 2015. YOY, insurers increased their swaps exposure only about 1%, compared to an 8% increase in 2014.

Insurers with derivatives exposure at the end of 2015 were domiciled in 43 states, but exposure was concentrated in Connecticut, Delaware, Iowa, Massachusetts, Michigan, Minnesota and New York, which together accounted for $1.59 trillion, or about 79% of the total.

Status: In 2010, Schedule DB was revised to be more streamlined and yet provide more detailed and useful information regarding an insurance company's derivatives exposure and activity. Further enhancements were adopted in August 2012 effective for reporting in 2013 onward. Continuing changes to reporting requirements are likely to reflect changes in the marketplace and different regulatory needs.