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DEFINITION OF 'INSURANCE DERIVATIVE'

A financial instrument that derives its value from an underlying insurance index or the characteristics ofan event related to insurance. Insurance derivatives are useful for insurance companies that want tohedge their exposure to catastrophic losses due to exceptional events, such as earthquakes or

hurricanes.

Unlike financial derivatives, which typically use marketable securities as their underlying assets,insurance derivatives base their value on a predetermined insurance-related statistic. For example, aninsurance derivative could offer a cash payout to its owner if a specific index of hurricane losses reacheda target level. This would protect an insurance company from catastrophic losses if an exceptional

hurricane caused unforeseen amounts of damage.

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The Insurance Industry and Hedging with Derivative Instruments

The primary use of derivative instruments in the insurance industry is hedging. Insurance companiesutilize derivatives in a variety of ways to manage and mitigate risks such as interest rate risk, creditrisk, foreign currency risk and equity-related risk that are inherent in their investment portfolios orliability structure. According to the Statement of Statutory Accounting Principles (SSAP) No. 86

Accounting for Derivative Instruments and Hedging, Income Generation, and Replication (Synthetic Asset) Transactions , a hedging transaction is defined as a derivative(s) transaction which is entered intoand m aintained to reduce the risk of a change in the fair value or cash flow of assets and liabilities or thecurrency exchange rate risk or the degree of foreign currency exposure in assets and liabilities.

With the changes to Schedule DB that were implemented in 2010, hedges are classified as eitherhedging effective or hedging other. A hedge generally is considered highly effective when the changein fair value of the derivative hedging instrument is within 80 to 125 percent of the opposite change in fairvalue of the hedged item attributable to the hedged risk. A hedge can also be designated as effectivewhen an R -squared of .80 or higher is achieved when using a regression analysis technique. Hedgeeffectiveness must be calculated and documented at the inception of the hedge and then monitored on aquarterly basis. It is typically expressed as a percentage. Insurance companies report hedgeeffectiveness at these two points in time on Schedule DB for each derivative position that is consideredan effective hedge. In instances where hedge effectiveness cannot be specifically calculated, insurancecompanies 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 deemedeffective for accounting purposes but still provide strategic value. If a derivative instrument is entered intofor hedging purposes, but the transaction does not qualify as an effective hedge as defined above, thehedge would be reported as hedging other in Schedule DB. Derivatives in the hedging other categorystill have the intended effect of managing and reducing risk, but simply do not meet the accounting anddocumentation requirements.

As of Dec. 31, 2010, a total of 193 insurance companies used derivative instruments to hedge risks intheir asset or liability portfolios. Of this number, 129 were life insurance companies, 49 wereproperty/casualty insurance companies, 11 were health insurance companies and four were fraternalinsurance companies. These insurance companies were domiciled in 39 states, with New York,Connecticut, Michigan and Iowa having the largest exposures. As mentioned in a previous CapitalMarkets Special Report, title insurance companies have no derivatives exposure.

This special report is the third installment in a series of Capital Markets Special Reports focusing onderivative instruments. It will focus on how insurance companies utilize derivatives in their hedgingstrategies and what types of risks or assets are being hedged.

Derivat ives Exposu re in Hedgin g Strategies

As of Dec. 31, 2010, 90.8% of the insurance industrys total derivatives exposure was used for hedgingpurposes. Drilling down further, 90.7% of the industrys over -the-counter (OTC) derivatives i.e.,options, caps, floors, collars, swaps and forwards reported in Part A of Schedule DB exposure was

used to hedge risk. In addition, more than 95.8% of the industrys futures contracts as reported in PartB of Schedule DB were used in a hedging strategy. The notional value of derivatives used byinsurance companies for hedging purposes totaled $786 billion at year-end 2010. The majority (or 91.3%)of the exposure was categorized as hedging other and the remaining balance was classified ashedging effective. Life insurance companies are the most active in using derivatives for hedging, with96.0% of the industrys total exposure.

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The overwhelming amount of hedges categorized as hedging other, as opposed to hedging effective,is likely a function of the recent changes to Schedule DB and corresponding reporting requirements. Asinsurance companies become more comfortable with the revised schedule and the requirements forproper documentation, there should be a better balance between the hedging effective and hedgingother categories. See the Hedge Effectiveness section below for further details.

The insurance industry uses derivatives to hedge various risks. The following table illustrates that themost common risk that is hedged by the insurance industry is interest rate risk; 64.3% of the total notionalvalue of outstanding OTC derivatives and futures contracts are used in mitigating risks resulting fromvolatility in interest rates. Insurance companies face interest rate risk on a daily basis in their investedassets portfolio as they are large buyers of fixed-income instruments, which are highly sensitive tomovements in interest rates. Equity risk is the second-most common risk that the insurance industryhedges with derivatives. 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 thatare hedged with derivative instruments include foreign currency risk and credit risk.

Swaps and options are the most widely used derivative instruments for hedging in the insurance industry.Swaps represented $442 billion (or 56.2%) of the insurance industrys derivatives exposure as of year -end 2010, and options represented $307 billion (or 39.0%).

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Swaps and Hedging

Drilling down further, interest rate swaps were the most common swaps derivative instrument utilized bythe insurance industry in their hedging strategies, representing $330 billion (or 74.8%) of the swapsexposure as of year-end 2010. In an interest rate swap, one party typically exchanges a stream of floatingrate interest payments for another partys stream of fixed rate interest payments (or vice versa). Interest

rate swaps are traded over-the-counter but are cleared through centralized clearinghouses, making themhighly liquid derivative instruments.

Although the market typically refers to notional values when referring to derivatives, it does not indicatethe true economic exposure that an insurance company might face. As discussed in the Capital MarketsSpecial Report titled, Insights into the Insurance Industrys Derivatives Exposure, potential exposuregives a better sense of the economic impact of a derivatives transaction at a given point in time. Forexample, the notional value of the insurance industrys interest rate swaps outstanding as of Dec. 31,2010, was $330 billion, while their potential exposure was $4 billion (or 1.3%) of the notional value. Thepotential exposure of foreign exchange swaps outstanding as of year-end 2010 was also a fraction (or1.1%) of the notional value of $54 billion.

Options and Hedging

When we take a more in-depth look at the options that insurance companies use for hedging, we see thatput and call options are the most commonly used derivative instruments. Put options represented $85billion (or 27.7%) of the options exposure as of year-end 2010, and call options represented $79 billion (or25.8%). The put and call options are predominantly equity index options, typically referencing an equityindex such as Standard & Poors.

The majority ($73.5 billion, or 93.0%) of the call options were purchased options, where the insurancecompany has the right, but not the obligation, to purchase an underlying asset for a specific price within aspecific point in time. The insurance company will benefit, and the value of the option will increase, if theunderlying assets price increases relative to the options strike price. The remaining balance ($5.6 billion,or 7.0%) represents written call options where the insurance company is receiving premiums from thebuyer of the call option. If the buyer exercises the option, the insurance company will be obligated to sell

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the underlying asset to the buyer at the agreed-upon price, or strike price. So long as the insurancecompany holds the underlying asset, the opportunity cost of writing a call option is not benefiting from theincrease in value of the underlying. As these call options were entered into for hedging purposes, theincrease (or decrease) in the options value would offset a decrease (or increase) in the hedged assetsvalue.

The majority ($76.8 billion, or 90.5%) of the put options were purchased options, where the insurancecompany has the right, but not the obligation, to sell an underlying asset for a specific price within aspecific point in time. The insurance company will benefit, and the value of the option will increase, if theunderlying assets price decreases relative to the options strike price. The remaining balance($8.1 billion, or 9.5%) represents written put options where the insurance company is receiving premiumsfor selling the option and is obligated to sell the underlying asset, if the buyer so chooses, at a specifiedprice. Again, an increase (or decrease) in the options value would be offset by a decrease (or increase)in the hedged assets value.

The caps category also consisted primarily of purchased caps ($61.7 billion, or 94.3%). For the most part,these were interest rate caps that insurance companies used in hedging interest rate risk.

Maturi ty Profi le of Derivat ives Exposur e The maturity of derivative instruments can vary greatly. Although OTC derivatives have becomesomewhat standardized, they can be tailored to meet the specific needs of an investor. For example, thematurity of a credit default swap (CDS) contract at creation is typically five years, but can be shorter orlonger in some instances. Futures contracts are highly standardized and their maturity is relatively short-term in nature, typically less than one year. The following chart provides the maturity profile of thederivatives exposure held by the insurance industry for hedging purposes:

As discussed in the Capital Markets Special Report titled, Insights into the Insurance Industrys CreditDefault Swaps Exposure, the maturity profile of the CDS held by the insurance industry waspredominantly (85.7%) five years or less. With the inclusion of interest rate swaps, foreign currencyswaps, and options, the maturity profile of the insurance industrys derivatives exposure is longer;derivatives maturing in five years or less represented 61.8% of the total notional value.

The majority of the longest-dated hedges (i.e., with maturity dates of 2016 and beyond) consisted ofinterest rate swaps totaling approximately $182.6 billion in notional value, or about 61% of an aggregate$300.4 billion notional value. This amount represents potential exposure, or an estimate of the futurereplacement/market value of the longest-dated hedges, of $3.1 billion on a total of $4.25 billion potentialexposure for all insurance industry hedges. On a more granular level, interest rate swaps comprisedapproximately 73% of the hedges with maturity dates of 2021 and beyond and 45% of the hedges withmaturity dates between 2016 and 2020. In addition, put options comprised a portion of the longest-datedhedges, at approximately 7% of the total notional value; purchased floors and purchased caps eachcomprised approximately 5% of the total notional value. About 32% of these longest-dated derivatives are

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Insurance Derivative Products: What's There

to Lose? by Richard C. Mason

Convergence between the capital markets and insurance is a well-known, if not well-understood, financial innovation. Products such as insurance derivatives and risk-linkedsecurities now embrace property catastrophe risks, political risk, weather-related risks,general liability and even extreme mortality. But while a derivatives contract may transferrisk, there is no requirement that the party seeking to transfer the risk is the one that bearsit. It is this facet of most derivative transactions that can distinguish such instruments fromtraditional insurance.

Insurance law has long held that genuine insurance is an indemnity product, meaning thatthe insured must first sustain a pecuniary (or bodily) loss, arising from what is called an

insurable interest, before a policy can be called upon to respond. For example, oneordinarily cannot insure against the risk of loss to a sea-going vessel owned by another,

unless ones cargo is aboard or one has some other pecuniary interest in the venture.Interests akin to a pure wager or speculative bet, moreover, fail to qualify as insurableinterests.

In a matter of potential international commercial significance, now on appeal to the Houseof Lords in England ( Anthony Feasey v. Sun Life Assurance Co. of Canada , et al), theEnglish Court of Appeals held that a reinsurance program that offered fixed benefits to aninsurer that was exposed to variable liabilities nevertheless adhered to the insurancerequirement of demonstrating an insurable interest. Though the accident and healthreinsurance product there did in fact pay the insured in excess of net losses actuallysustained, the Court of Appeals found it was intende d that there should be a closerelationship between the amount of fixed benefits and the liability of the beneficiary, itself

a liability insurer. If the English courts the original source of a great deal of fundamentalU.S. insurance law uphold the enforceability of an insurance product that pays at varianceto any loss to the insured, then the door may be opened to recognition of insurance eitherwithout loss or, at least, without congruent loss.

Potentially at issue, in this regard, are a number of increasingly popular financial riskmitigation or transfer instruments. Many insurance derivatives, for example, are options inwhich the sellers of call options agree to pay the protection buyer if a dollar level on aspecified index of property and casualty losses is exceeded. Importantly, unless the termsprovide otherwise, the protection buyer seeking insurance likely will not be required to havesuffered any insured loss itself.

Because of the loss issue, a threshold consideration when examining any insurancederivative product is to ensure that any necessary regulatory authorization is satisfied.Many U.S. state insurance departments, for example, do not regard risk-linked securities ascontracts of insurance. Some question whether swaps constitute contracts of insurance andhave suggested that index structures that do not correlate to the insureds actual lossesmay not be regarded as insurance.

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The insurance character of a risk transfer instrument also can implicate tax considerations.In more than one instance, the tax code does not allow insurance-related deductions absenta transfer of risk. This is why the IRS has disallowed deductions for premiums paid to awholly owned captive insurer in situations in which the captives dividend payable to theinsured depended upon the insurance results. Premiums paid for options, likewise, are notdeductible until they lapse and then result in, and qualify as, capital losses. In a tax ruling

on retroactive liability insurance, the IRS held that a mere timing risk is not an insurancerisk. In that instance, the insurance product was issued after a hotel fire, and after theliabilities were known, but sought to insure against the risk that injured claimants mightcollect damages sooner rather than later.

Despite the potential challenges of enforceability, regulatory hurdles and tax law nuances,there are many insurance derivative or hybrid products that confer solid protection and offeradvantages in capacity and liquidity that are unavailable in the traditional marketplace. Ifthe product under consideration is not a classic indemnity product, involving a fullycongruent assumption of risk of loss, it can still be a valuable insurance product so long as itis carefully structured and negotiated by parties with a mind both to the future of insuranceas well as its past.