Insurance Europe questions plans on uncleared swaps

Proposed rules under Emir could place a high cost burden on insurers, says industry association

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Proposed rules on uncleared swaps trades will place an unreasonable burden on insurers, according to industry association Insurance Europe, imposing a cost burden on firms that would discourage hedging and would ultimately be passed on to policyholders.

In a July response to a consultation on draft regulatory standards for uncleared trades under the European Market Infrastructure Regulation (Emir), Insurance Europe highlighted concerns about the speed with which new rules will be introduced and worries about the eligibility criteria for collateral.

“Every effort should be made to ensure that costs associated with non-centrally cleared derivatives do not become prohibitively high and eventually harm policyholders,” stated the association.

“Our concern goes far beyond the IT and operational costs to firms,” says Cristina Mihai, policy adviser, investments, at Insurance Europe, based in Brussels. “Post-Emir, insurers will have to hold cash for covering daily variation margins, and that could have an impact on asset holdings. Insurers typically have limited holdings of cash, especially life insurers. The pressure to hold cash could be the highest cost for the insurance company. What the impact of that will be, we will only see over time.”

Emir will require all derivatives trades either to clear centrally or to meet the criteria being set down for uncleared transactions. For both types of trade, insurers will face more stringent requirements to post initial and variation margin.

The European supervisory authorities (the European Securities and Markets Authority, the European Banking Authority and European Insurance and Occupational Pensions Authority) are expected to submit draft technical standards to the European Commission towards the end of the year after which finalised rules will be submitted to the European Parliament and Council early in 2015, leaving only months from the regime becoming official to the rules taking effect.

“You can say that insurers have had time to prepare and they were aware of the potential rules, but that isn’t true. There are a number of provisions that must be reflected in each and every bilateral contract, so firms will have to renegotiate contracts on a bilateral basis,” says Mihai.

Insurers will have to renegotiate the terms of many existing derivatives contracts to accommodate new credit criteria and concentration limits that apply to the assets they post as collateral. Firms will also face an operational challenge to prepare to carry out daily collateral exchanges and manage the composition of collateral pools as required under the new rules.

For example, the proposed rules impose a maximum of 50% on the amount of government bonds from a single issuer in a collateral pool, meaning firms must rebalance a portfolio if changing asset prices mean they exceed that limit.

“If sovereign bonds go up and you discover that the weighting in the collateral portfolio is higher than allowed, you need to rebalance the portfolio. Most likely insurers will rebalance with what they already have, but even so, insurers will need to redefine a huge number of procedures. It is not something that can be done in just a few months,” says Mihai.

These concentration limits aim to protect against a counterparty being unable to sell collateral quickly when needed. But Insurance Europe points out that the requirements on sovereign debt contradict the position in Solvency II where government bonds are treated as highly liquid and thus exempted from capital charges for concentration risk. “In the euro area, it is hard to imagine how the dissolution of a collateral portfolio could cause a liquidity problem,” says Mihai. 

The association also takes issue with credit quality requirements where the proposals appear to be drafted in line with bank practices rather than those of insurance companies.

“The currently foreseen provisions regarding initial margin and haircuts focus on aspects and requirements of the banking sector and do not cater for the specifics of the insurance business,” states the association in its consultation response. The proposals set minimum credit ratings for eligible collateral, but these are higher for firms operating internal credit models than for firms relying on external credit rating agencies.

“We understand the need to create incentives for firms to develop internal credit ratings but an incentive for one firm shouldn’t be a limitation for another,” says Mihai. Even medium-sized to large insurers do not have the resources or expertise to derive credit ratings internally, she explains, suggesting instead a flat requirement that all collateral above credit quality step 3 (Standard & Poor’s BBB- or above) be eligible to post.

Emir requirements on variation margin for uncleared trades will take effect from January 1, 2016 and affect all insurers.

Requirements relating to initial margin will come into effect in stages between the end of 2015 and 2019 depending on the size of firms’ derivatives portfolios. Mihai does not see any insurers exceeding the threshold set for compliance in 2015, but believes most of the top 20 firms will fall under the rules by the time the final threshold (OTC derivatives exposure of more than €8 billion (£6.3 billion) gross notional outstanding) comes into effect at the end of that period. 

In a separate filing in response to the consultation, German insurance company Allianz argued that unclear wording in the rules will prevent intragroup transactions. These are used by insurers to transfer risks such as forex exposures from subsidiaries to group level or to offset risks between individual entities and are intended to be exempt from the Emir rules.

However, the rules as proposed would stop insurers using the exemption, says Allianz. “An unlimited inclusion of restrictions stemming from insolvency or similar regimes as a criterion for a legal/practical impediment [to using the exemption] would de facto eliminate the possibility to grant intra-group exemptions,” stated the insurer in its submission, explaining that most insolvency laws limit the right to dispose of assets in specific circumstances.

Meanwhile, Insurance Europe also said that the latest draft Solvency II Delegated Acts do not reflect the aims of G-20 derivatives reforms and Emir. Provisions for derivatives counterparty default risk in the draft Solvency II Delegated Acts (which set much of the detail for the directive) were composed in 2011, before Emir, and have not been changed since. However, the Omnibus II directive in November 2013 included a recital to reflect recent developments, acknowledging the difference in risk between centrally cleared and bilateral derivatives trades. This position is not reflected in the most recent draft of the delegated acts, according to Mihai.

“In Solvency II, there is no difference made between centrally cleared derivatives and over-the-counter derivatives post-Emir. All of them get the same treatment,” she says.

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