UK insurers recoupon interest rate swaps in bid to enhance yield

Unwinding in-the-money swaps to release cash for investments and collateral management

UK insurers are renegotiating their in-the-money interest rate swaps to release cash to invest in higher-yielding assets and reduce the cost of servicing collateral, according to market participants.

Insurers holding fixed receiver swaps entered into when interest rates were high have seen the mark-to-market value of these positions rocket in recent years as rates have plummeted. At the same time, falling rates have reduced the yield insurers can achieve on the asset portfolio.

Shazia Azim, a partner at PwC in London explains: "Insurers are looking ahead and thinking it would be a smart idea to realise the ‘in-the-money' value of their swaps and invest it in something else. Some of the hedges the UK insurers have in place are pretty large – certainly large enough to justify monetising."

To realise the cash value tied up in their swaps, insurers can unwind the in-the-money hedges in exchange for a lump sum from the counterparty. This can then be invested in higher-yielding assets. The insurer can then enter into a new swap struck at current market rates to retain their interest rate protection in a process known as recouponing.

UK firm Friends Life is one insurer that has recouponed its interest rate swaps in the second quarter of this year. The group invested the proceeds in a mixture of safe credits, including cash instruments, inflation-linked gilts and investment-grade corporate bonds in order to boost investment returns.

"By recouponing these swaps [now], Friends Life was able to release the value of these positions, invest the proceeds in order to increase returns and then replace the hedges at current market rates," says a spokesperson.

"The [interest rate] hedges are regularly reviewed in order to take account of changes in liabilities, changes in the relative attractiveness of different hedging instruments, the extent to which the hedges have moved in or out of the money and market timing," the spokesperson adds.

But there are limits to the amount of yield enhancement to be gained on the back of recouponing, say bankers.

David Prieul, head of the insurance and pensions solutions group in Europe at Credit Suisse in London, says insurers will need to hold back some of the cash to use as collateral for servicing the new at-the-money swaps they enter into. "Nevertheless, one can save a portion of that and reinvest into assets that earn a spread over the implied rate of return of the derivative collateral," Prieul adds.

Some insurers, such as Aegon UK, are recouponing their swaps to reduce the cost of servicing the collateral posted by their counterparties.

Colin Black, Edinburgh-based market and credit risk director at Aegon UK, says the insurer was receiving significant amounts of collateral from the banks as its swaps turned in-the-money. "The collateral was in the form of cash and we had to pay the banks a target interest rate on that by investing in the money markets. Through that process we were adding counterparty exposure to our balance sheet," Black says. "By turning the clock back to zero by recouponing, the risk and burden of servicing that collateral was eased."

The windfall from recouponing can also be used to pay for changes to the credit support annexes (CSAs) of derivatives contracts as counterparties look to align with new rules around the central clearing of derivatives.

More and more firms are electing to set up so-called clean CSAs that accept only cash and gilts as collateral in a single currency to bring them in line with new clearing requirements.

Changing CSA terms can force costs onto insurers to account for the change in value of the collateral portfolio, says Emily Penn, London-based director of insurance asset liability management at Royal Bank of Scotland.

"Where a recoupon is done in parallel with a clean-up of a CSA there will be a change in the discount rate to value the swap, because the discount rate is based on the collateral that can be posted under the terms of the swap.

"The insurer may receive or pay this fee depending on the size and nature of the underlying portfolio. The recoupon exercise may help fund some or all of the cost of changing to a clean CSA," she says.