Analysts at Moody’s have assured that large UK life insurers using swaps to hedge their interest rate exposure should be able to absorb the cash collateral requirements within their liquidity buffers, following the sharp fall in UK government bond prices and Bank of England interventions.
Yields on 30-year gilts peaked at around 5.1% on 28th September before the BoE announced steps to stabilize the market, with a near 1.4 percentage point rise in yields triggering significant margin calls on interest rate hedges collateralized by gilts.
While this chiefly affected UK pension funds, Moody’s notes that UK life insurers that use swaps to hedge their interest rate exposure would also have had to post additional collateral.
However, the rating agency expects that large UK life insurers would have been able to absorb the cash collateral requirements within their liquidity buffers, and that they are well positioned to navigate possible additional volatility when the BoE scales back its intervention.
Moody’s contends that UK life insurers with annuity liabilities would have been most affected by collateral calls, although the impact will also depend on the extent to which they had hedged the risk of interest rates declining.
To limit volatility in their Solvency II capital ratios, UK life insurers tend to hedge the impact of falling interest rates on the capital held against their annuity liabilities.
Under Solvency II rules, liabilities are discounted to their present value when calculating capital requirements, and falling interest rates result in a lower discount rate, and consequently higher liabilities and capital requirements.
Conversely, rising interest rates lead to lower capital requirements on long duration annuity business, meaning interest rate swaps that are used to hedge this risk require cash collateral to cover any negative movement in the swap’s value.
But while the rate at which gilt yields rose was significant, Moody’s says the large UK life insurers hold substantial liquidity to help them navigate stress scenarios without having to sell longer duration assets.
“Given the apparent shift in the trajectory of interest rates, and potential for market volatility, we expect insurers to re-evaluate their hedging strategies and to reassess how much protection they need against the risk of lower interest rates,” Moody’s concluded.