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How insurance accounting teams can enable new investment strategies | Hedging floating rate investments

  • aaron jacob headshot

    Authors

    Aaron Jacob

    Director
    Financial Services

    Insurance | Denver, CO

  • steven castleton headshot

    Authors

    Steven Castleton

    Managing Director
    Financial Services

    Insurance | Kennett Square, PA

Summary

Investment accounting professionals can add significant value by proactively preparing, both technically and operationally, to support new hedging strategies.

Is your investment accounting team ready to support new investment strategies for weathering today’s volatile market and tomorrow’s potential economic downturn? As your CIO and portfolio managers seek new investment strategies, you can support them by driving internal assessments and readiness. By following these industry best practices, you can become a key contributor to the strategic repositioning of your balance sheet.

Seeking yield in today’s market

Today’s Insurance CIOs must manage investment portfolios through unprecedented volatility. Not only must they evaluate the portfolio performance following recent upheavals in the credit and interest rate markets, but they must also determine how to position the portfolio to improve yield and maintain credit quality under new market paradigms. Trends in asset allocations suggest insurers will continue to seek yield in structured products, alternative assets, and foreign markets. These investments likely require hedging. As an investment accounting professional, you can add significant value and enable this critical reallocation by proactively preparing, both technically and operationally, to support new hedging strategies and associated hedge accounting needs.

As an investment accounting professional, you can add significant value and enable this critical reallocation by proactively preparing, both technically and operationally, to support new hedging strategies and associated hedge accounting needs.

Derivative use in life insurance investment strategies

Roughly 100 of the largest life insurers use derivatives to manage risk and enable investment strategies. Total derivative use across these largest insurers is about 100,000 transactions with a combined notional of nearly $2.4 trillion. The graphics below illustrate how the total derivatives use by life insurers compares with that of the real estate and banking industries. As shown, insurers hedge a larger percentage of their balance sheet. However, the percentage of derivatives for which hedge accounting is applied is dramatically lower. As a result, some investment accounting groups are less accustomed to the rigors of applying hedge accounting — including the processes and technology required to operationalize new hedge accounting programs.

Two charts showing derivative and hedge accounting usage by percentage

Industry investment trends

For the past few years, CIOs have considered an increasing number of strategies to capture yield, and many of these strategies expose insurers to new market risks that can be hedged. As a result, investment accounting teams must increasingly determine not only whether hedges qualify for hedge accounting, but also if systems exist to streamline the required testing for the volumes of trades needed to make a difference in net interest income. The need for quantitative analysis to prove hedge effectiveness has increased, and that analysis must incorporate the assumptions needed to qualify for hedge accounting. In the coming months and years, the need for hedge accounting knowledge and robust systems will only increase.

One trend in asset allocation is portfolio managers’ increased use of higher-yielding, floating-rate structured assets (e.g., real estate loans, CLOs, RMBS). Because these instruments yield floating-rate returns, insurers typically enter into hedges to lock in fixed returns to better match long-dated liabilities. The growing popularity of these structured products — and the increased derivative portfolios that follow — mean your investment accounting team must be prepared to support hedge accounting for your firm to fully utilize these economic strategies.

Critical considerations for accounting teams

The following checklist summarizes critical considerations for investment accounting teams when supporting this economic investment alternative:

Economics

Strategy

The result of this strategy is to lock in a high-credit-quality fixed return.

  • Invest in high-credit-quality, floating-rate structured assets.
  • Convert floating-rate assets to fixed by executing a receive-fixed interest rate swap.

Outcome

  • Generate higher interest income
  • Lock interest income by converting to fixed returns
  • Swaps can start now or 1–3+ years into the future

Hedge accounting

Qualification considerations

To qualify for hedge accounting, you must meet qualifying criteria.

  • Ensure the bond is contractually specified to a floating-rate index, such as LIBOR.
  • Match economic terms of the swap and the asset.
  • Determine the likelihood that the asset will remain outstanding through the life of the hedge (i.e. the probability that the cash flows will exist).
  • Assess the need and ability to hedge pools of assets. This can help with meeting the probability threshold above, but you must assess each pool for alignment with the swap terms.

Hedge documentation

  • Ensure thorough documentation is in place at inception or at trade execution.
  • Perform regression testing by the end of the quarter to quantitatively prove the effectiveness of the hedge.
  • Consider using a qualitative approach and understand the pros and cons.

Operational considerations

  • Ensure necessary journal-entry accounts are set up in advance.
  • Align internal stakeholders and establish processes and controls throughout the trade life cycle.
  • Find efficiencies in regression processing by leveraging technology and strategically selecting the timing of quantitative testing.
  • Partner with experts to review and/or outsource processes to improve efficiency and effectiveness.

Additional tips

  • Involve auditors early and obtain approvals to avoid surprises.
  • Construct a well-articulated position and proposed accounting methodology.
  • If the economics are aligned but the hedge is failing, reassess the accounting methodology. Good economics usually lead to qualifying hedges.

In times like these, you do not want to be the bottleneck for timely execution on critical hedging strategies. No investment accounting group wants to say “no” to a strategically important, yield-enhancing strategy. CIOs and portfolio managers continually look to the future for new investment strategies, and your investment accounting team can help drive internal assessments and readiness. Rather than waiting for front offices to propose new strategies, your team can proactively perform research and ready your organization for hedge accounting and increased derivatives use cases. This will prepare your organization to weather market volatility and elevate your team’s role within the organization.

Learn More

A leader in debt and derivatives solutions, Chatham Financial serves clients across industries including insurance, asset management, financial services, banking, private-equity, real estate, and corporates. We work with clients to develop, execute, and operationalize financial risk management strategies aligned with their objectives. Our solutions include expert advisory services in all phases of derivatives operations, and technology offerings that enable clients to scale their programs efficiently.



Talk to an expert

Learn more about hedging and hedge accounting for floating rate investments.

About the authors

  • Aaron Jacob

    Director
    Financial Services

    Insurance | Denver, CO

  • Steven Castleton

    Managing Director
    Financial Services

    Insurance | Kennett Square, PA


Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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