The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S.

Insurers' Counterparty Exposures

Primary Credit Analyst: Maftuna Azizova, Dallas (1) 214-765-5861; maftuna.azizova@standardandpoors.com Secondary Contacts: Robert N Roseman, New York (1) 212-438-7236; robert.roseman@standardandpoors.com Blake Mock, New York (1) 212-438-7278; blake.mock@standardandpoors.com

Table Of Contents
Dealer Designations Insurance Industry Exposure To Derivatives Collateral Relative To Exposure How Does This Affect Our Ratings? Minimal Impact On Earnings Potential Effects On Risk Management And Risk Mitigation

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The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S. Insurers' Counterparty Exposures
In response to the financial crisis of 2008, the U.S. Congress passed the Dodd-Frank Act (DFA), officially known as the Wall Street Reform and Consumer Protection Act of 2010, with provisions targeting a wide variety of financial markets. Among the law's many provisions is Title VII, also known as "Wall Street Transparency and Accountability," which aims to boost transparency in the pricing of derivative transactions--specifically swaps, which insurers and others financial institutions commonly use. Swaps within the scope of this regulation are defined in section 1a of the Commodity Exchange Act and include, but are not limited to, interest rate swaps, credit default swaps, and total return swaps. Insurers employ derivatives primarily to hedge against specific risks in their investment or liability portfolios. Derivatives used to generate income are generally a very small proportion of insurers' total investment holdings. Standard & Poor's Ratings Services believes that Title VII could improve insurers risk management processes. We also believe Title VII could have an impact, albeit it a minor one, on our ratings on the insurance industry. This regulation requires financial institutions to register with the Commodity Futures Trading Commission (CFTC) or the SEC if Title VII designates the institutions as "swap dealers," "security-based swap dealers," or "major swap participants" (MSPs). After registration, insurers will be subject to strict regulations, including capital and margin requirements, business conduct standards, and reporting and disclosure rules, as well as requirements to mark to market both cleared and noncleared swaps daily. Based on the CFTC's and SEC's final rules, we expect many life insurance companies to be designated as swap dealers because insurers regularly enter into swaps with counterparties as an ordinary course of business for their own accounts. Overview Title VII of the Dodd-Frank Act, a.k.a. the "Wall Street Transparency and Accountability" provision, aims to boost transparency in derivative transactions. Insurers use derivatives to hedge against specific risks in their portfolios, and we believe Title VII could improve insurers risk management. We also believe Title VII could have an effect, though a small one, on our ratings on the insurance industry.

It's also possible that the Federal Insurance Office (FIO) may recommend insurers not be designated as any of the above nor be held to the same regulatory standards as banks since the departments of insurance of the states where the insurers are domiciled already strictly regulate the industry. Nonetheless, among many phase-in periods defined in Title VII, non-bank Phase 2 entities, which include insurers not categorized as either swap dealers or MSPs, are required to comply with the trade-execution requirements under the regulation that started on June 10, 2013. The CFTC and the SEC make the final determination as to which swaps fall within the scope of clearing requirements.

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The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S. Insurers' Counterparty Exposures

Currently, "plain vanilla" interest rate swaps (for example, LIBOR-based fixed- or floating-rate swaps with three-, five-, or 10-year tenors), credit default swap indices (CDX), and single-name credit default swaps (CDS) written on constituents of CDX must be cleared through exchanges. It's highly likely that other single-name credit default swaps, which reference corporate names not in the CDX indices, will eventually be also have to be cleared through exchanges. Foreign exchange swaps and forwards are now excluded from Title VII clearing requirements. Clearing through the exchanges allows for transparent pricing of these instruments, increases liquidity, and reduces counterparty exposure through required collateral posting. Previously, over-the-counter (OTC) instruments did not require collateral posting if both of the counterparties involved in the transaction agreed to these terms. Cleared positions will be subject to initial and variation margins. The variation margin is based on the marking-to-market of swap derivatives where the counterparty with an unrealized loss will post collateral. Once the DFA takes full effect, issues may arise regarding netting unrealized gains and losses with the same counterparty if some of those swaps are cleared through an exchange facility and some are not, as well as with calculating CDS margins on bonds that are not very liquid (that is, rarely traded in the market). Because clearinghouses typically apply a value-at-risk (VaR) analysis based on bond prices or spreads, it may be difficult to determine the CDS margin given the lack of historical data. So, clearinghouses may not offer clearing of CDS that reference these types of bonds.

Dealer Designations
Companies receive an MSP designation based on their substantive total position or total counterparty exposure. Insurance companies designated as MSPs may be at a competitive disadvantage relative to those that are not because they incur additional costs for reporting and capital requirements. Based on our research, we believe many smaller insurance companies will fall under the swap dealer designation as a function of their separate account holdings, although the DFA does not clarify whether separate accounts are counted as the company's own accounts. If separate accounts and the derivative holdings within those separate accounts are counted as an insurer's own business, many insurers will fall into the swap dealer category--particularly if the exception of hedging risks against their own products is not approved by the regulators.

Insurance Industry Exposure To Derivatives

As of year-end 2012, the notional amount of the insurance industry's exposure to derivatives was $1.53 trillion, with swaps (as defined in the statutory filings) comprising $863 billion. Life insurance companies held 95% of all insurance industry derivatives based on the notional amount and 97.5% of all insurance industry swaps, including interest rate swaps, foreign exchange swaps, and CDS. Based on our research, initial and variation margins on cleared swaps may be as high as 4% to 6% of the swaps' notional amount. Life insurers are exposed to an $842 billion notional amount, so the required posted margins must be in the $33.6 billion to $50.5 billion range for the industry. In light of the $3.5 trillion in total cash and invested assets life insurers currently hold, this translates to 1.0% to 1.5% of total investments they may have to post in eligible collateral. We base this estimate on our assumption that all types of swaps insurers use will have to be cleared. Considering the netting that occurs with each only a fraction counterparty, these estimates may turn out to be of the estimated full $33.6 billion to $50.5 billion.

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The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S. Insurers' Counterparty Exposures

Collateral Relative To Exposure

We have calculated that cash, cash equivalents, and short-term securities make up 3.06% of the total investments for the insurers we rate; 3.77% of total investments are in U.S. Treasuries, which can be relatively quickly and easily converted to cash using repurchase agreements (repo) and securities-lending programs, with small haircuts applied to the notional amount of the posted assets. Some clearinghouses expect to offer services allowing members to post corporate bonds or other high-quality assets, such as U.S. government agency bonds, as collateral (see "My Bonds Are My Bond: The Risks And Rewards For Clearinghouses And Depositories Amid The Scramble For Collateral," published Dec. 18, 2012, on RatingsDirect). However, given the huge market for derivatives, shortages in cash and high-quality assets may occur, so the haircuts repo counterparties offer may increase due to demand. And because margin calls rise in highly volatile markets, there may be a shortage of available liquidity provided by either clearinghouses or banks. But we believe the insurance industry in general--especially in light of the total amount of its liquid assets--will not rely on repo transactions as a primary source of liquidity for collateral posting.

How Does This Affect Our Ratings?

We don't expect these new regulations to have much of an immediate impact on our ratings on insurers, and any rating implications will affect life insurers more than non-life companies. The implementation of these requirements may also affect our views on insurers' liquidity and financial flexibility. As part of our ongoing analysis of the DFA, we will closely monitor companies that are moderate to heavy users of swaps. In general, Title VII will affect life insurance companies to a greater extent than non-life insurers because the former have the largest proportion of the overall industry's derivative exposure. Life insurers use swaps for hedging interest rate risk in certain lines, such as permanent life products, annuities with guaranteed minimum crediting rates, guaranteed withdrawal or death benefits, and other interest-rate-sensitive businesses. Insurers also use CDS to reduce credit exposure to single-name concentration risks. Interest rate swaps and CDS account for 80% and 5%, respectively, of the notional amount of all swaps now used by the life insurance industry. In some cases, life insurers write CDS in order to synthetically replicate corporate bonds. The table below illustrates the sensitivity of each insurance business line to various macroeconomic risks. Life products that policyholders use for asset accumulation purposes are highly sensitive to interest rate risk. Therefore, insurers that are primary issuers of these types of policies use interest rate swaps to hedge their exposure. On the other hand, property/casualty (P/C) insurers generally are not highly sensitive to interest rate risk, which explains why P/C insurers make up only 5% of the industry's total swap usage. Life insurers' relatively high derivative usage arising from their substantial exposure to interest rate risk is why we believe Title VII will affect them more than other insurance subsectors.

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The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S. Insurers' Counterparty Exposures

Insurance Macroeconomic Risk Matrix

Sensitivity/rating bias analysis --Life-Risk factors/sectors --Life: Asset accumulation---Health--

Protection General account Separate account Private sector Government programs L L H H

Economic development (real GDP) L Market risk Interest rate Equity Credit Employment conditions Inflation trend (CPI/PPI/other) Legislative/regulatory/judicial Catastrophic event M L H L L M L

H L H L L M L --Property/Casualty--

M H L L L M L

L M L H M H M --Other--

L L L H M H M

Risk factors/sectors

Personal

Commercial M

Reins H

Bond M

Broker M

Economic development (real GDP) L Market risk Interest rate Equity Credit Employment conditions Inflation trend (CPI/PPI/other) Legislative/regulatory/judicial Catastrophic event M M L L M M H

M L L M H M M

M M L M H M H

M L H M L L L

H L L M L M H

Note: The letters stand for the following forward-looking sensitivity designations: H--High; M--Medium; L--Low.

We believe the majority of insurance companies hold sufficient liquid assets (cash and short-term investments). But if the portion of liquid assets allocated for collateral posting becomes too great, this could lead us to revise our assessment of an insurer's liquidity and financial flexibility.

Minimal Impact On Earnings

Given our initial estimation that insurers have enough cash and cash equivalents to post as collateral to clearinghouses, we believe they will not suffer any opportunity cost in holding additional cash specifically for collateral-posting. While further reporting and record-keeping requirements are likely, we believe these will largely result in only a modest increase in administrative expenses and not have a major impact on earnings or reporting volatility. For annuity and participating whole life lines, insurers may pass any potential additional costs on to policyholders in the form of reduced crediting rates. And, since we do not expect these costs to be significant, we also don't anticipate this change will affect policyholder behavior, such as disintermediation.

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The Dodd-Frank Act: Title VII Swap-Clearing Requirements Could Lower U.S. Insurers' Counterparty Exposures

Potential Effects On Risk Management And Risk Mitigation

Companies that we score as having strong or excellent ERM invest significant resources in risk measurement and risk mitigation techniques. These programs include heavy use of derivatives that fall under Title VII. Due to potentially minimal increases in the cost of executing hedges, we believe ERM best practices, particularly interest rate and credit risk management, will not deteriorate or lead to looser (that is, leaving more risk in the book than before) hedging targets. We also believe that companies with strong risk controls will continue to closely monitor liquidity risk due to collateral-posting requirements. The transition from OTC hedging to clearinghouses will potentially enhance the transparency and liquidity of the derivative market in general. From a credit risk perspective, we see this as improvement to an organization's risk mitigation within its ERM framework. Since derivatives primarily hedge against specific risks within insurers' investment or liability profiles, and derivatives used to generate income are generally a very small proportion of their total holdings, we don't anticipate the use of such instruments will have a significant impact on our ratings on insurance companies.

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