Will Hedging Demons Haunt Q3 Life and Annuity Issuer Earnings?

The publicly traded U.S. life and annuity issuers are set to start releasing their third-quarter earnings eight days before Halloween: Oct. 23.

Securities analysts are already factoring in impressions of how the issuers have handled low interest rates in general, and how well they have priced and managed old blocks of stand long-term care insurance.

This quarter, another issue could start to fly out of the shadows of the earnings report footnotes and spook investors: How well life and annuity issuers have handled their "hedging programs." Securities analysts at Morgan Stanley, for example, mention hedging several times in their new third-quarter earnings preview report.

The analysts talk about concerns about dollar-yen exchange rate hedging concerns for Aflac Inc. and Prudential Financial Inc.

The analysts cite variable annuity guarantee hedging costs as an item that could help AXA Equitable report either surprisingly low or surprisingly high third-quarter earnings. The analysts see managing variable annuity guarantee hedging costs as a component of AXA Equitable's "ability to manage the risk associated with the variable annuity operations while continuing to grow its more profitable group retirement and asset management operations."

Uh, what is 'hedging'?

For a life insurer, 'hedging' is the use of a contract with another organization to try to reduce or eliminate various types of investment risk.

A life insurer that is protecting annuity holders against drops in interest rates might try, for example, to eliminate its own exposure to drops in interest rates, by paying another financial services company for an arrangement that would pay off if and when interest rates drop sharply. If rates did drop sharply, the life insurer would use cash from the other company to make up for the cost of providing a minimum level of interest for the annuity holders.

A life insurer could use other arrangements to protect against changes in stock prices, or changes in the relative value of the U.S. dollar and other world currencies.

What could make hedging 'ineffective'?

One challenge, for hedging users, is that, even if the arrangements work exactly as expected, they may compensate the insurer for only part of the change in the value of the hedged item.

If you sell disability insurance, for example, you may have clients who use disability insurance to insure only 60% of their income, with the understanding that they will have to use other mechanisms to compensate for the 40% gap between the insurance benefits and pre-disability income. Insurers, similarly, may use hedging to hedge against only part of the impact of the various types of investment market risk that they face.

A second challenge is that hedging arrangements are complicated. Even if hedges work properly, they may work differently than the life insurers expect.

A third challenge is that the hedging counterparties could fail.

The Chicago Mercantile Exchange, a major market for hedging arrangements, has posted a KPMG primer on hedge effectiveness testing and measurement, on its website. In that guide, which is aimed at a general financial services player audience, KPMG notes that one rule of thumb is that a hedge that offsets 80% to 125% of a purchaser's hedged losses is typically regarded as effective.

KPMG notes that the credit risk of the counterparty is an important part of predicting how well a hedging instrument might work.

Why could hedging pop up in issuer earnings reports in the next few quarters?

Rating analysts have drawn attention to the importance of hedging in recent actions related to Ohio National Financial Services Inc. Ohio National is a Cincinnati-based mutual that was founded in 1908 and has been known for having a careful, community-minded approach to the insurance business.

Like other insurers, Ohio National has used a variety of hedge investments to support annuity guarantees.

Rating analysts at Moody's Investors Service have questioned whether the company's hedging strategy is comprehensive enough or would be effective enough in a crisis. The company has responded by backing away from selling new annuities.

Members of the Financial Condition Committee — an arm of the National Association of Insurance Commissioners — have been drafting new accounting and reporting guidelines for insurers that use financial derivatives contracts to hedge against the interest rate risk involved with offering variable annuity benefits guarantees.

Regulators at the NAIC have said they want to make it easier for insurers to use hedging, not harder, but it's possible that the proposed reporting changes could lead to more hedging-related ups and downs in insurers' earnings.

Ohio National's situation has raised questions about whether Ohio National has been unusual, or unusually unlucky, or whether its executives have simply been quick to see how the proposed hedge accounting rule changes might affect its guarantee hedging efforts.

Insurers commonly talk about the effects of interest rate, currency exchange rate and stock market changes on their performance when they release their quarterly and annual earnings. Insurers also report on the performance of their derivatives contracts and other hedging arrangements.

But the NAIC focus on the terms "hedge effectiveness" and "hedge ineffectiveness" could lead to those terms showing up more often and more prominently, alongside more general remarks about economic "headwinds" and "tailwinds."

— Read 7 New Peeks Inside Annuity Issuers' Curtains, on ThinkAdvisor.

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