Hedging yields on floating rate assets

During the past decade of low interest rates, insurers changed their general account asset allocations to improve yield. Many insurers invested in foreign private placements, commercial mortgage loans, middle market loans, and structured securities like CLOs. The most pronounced asset allocation increase was investments in CLOs and other asset-backed securities, which brought increased yield with comparable credit risk. However, these assets tend to have floating rates that create a short-duration gap against the typical long-duration profile of most life insurers' liabilities.

While rates were low insurers avoided hedging hoping to benefit from potential rising rates. Now that rates are sharply up — with an inverted yield curve implying a future drop in rates — many insurers are considering hedging a portion of their floating-rate portfolio to lock in current market rates and maintain higher yields.

When deciding whether to hedge floating-rate assets there are several key economic and accounting considerations.

Economics

The core economics of the hedge are straightforward. An insurer with assets based on a SOFR index could structure a swap to match the index, notional, and tenor, thereby creating an effective hedge. Most of the time, floating-rate investments aren’t this simple. Below are several key economic and accounting considerations:

Pooling

Generally, insurers want to pool assets to minimize the number of derivatives needed to hedge, reducing the cost and administrative burden of hedging. Further, this strategy allows insurers to originate or acquire new assets into the pool to replace assets that prepay or are sold. The downside is that pooling can potentially reduce the precision of the hedge (see Resets and Floors below).

Probability

Insurers must consider estimated prepayments, sales, and new originations/acquisitions in determining whether the assets will be outstanding through the life of the hedge. If assets prepay faster than expected, the insurer could end up over-hedged, which could reduce the economic effectiveness of the strategy.

Resets

The assets in the pool will reset on different dates. To establish the reset date on the derivative, an insurer can select either a weighted average reset date or simply the date in the middle of the month/quarter. Neither approach is perfect, but both approaches will be highly effective.

Floors

If the assets have interest rate floors and the swaps don’t, that mismatch could affect the economic effectiveness of the hedge. Portfolio managers are hesitant to sell floors in the swap — if rates fall the floors in the asset are an economic benefit that would be lost to the sold floor in the swap. Hedging floored assets with an unfloored swap provides great economic benefits when rates fall.

Accounting

Most insurance companies want to achieve hedge accounting on hedges of floating assets. Economic matching, hedge accounting guidance, and the underlying interest recognition on the assets are key considerations:

Interest recognition

Most assets use contractual/accrual accounting for interest recognition that matches the contractual/accrual recognition on the floating leg of the swap. However, some floating rate assets have interest recognition patterns that differ from traditional interest recognition, especially lower credit quality asset-backed securities. Hedge accounting for these types of assets may not be as straightforward to apply. Knowing the interest recognition pattern is an important step in applying hedge accounting.

Qualifying for hedge accounting

To qualify for hedge accounting the following criteria must be met:

• The forecasted transactions must be probable of occurring.
• The entity must have an expectation that the hedging relationship will be effective.
• Assets within the same pool must have the same or similar economic characteristics.
• The hedging relationship must meet the documentation requirements in the accounting guidance.

If an entity wants to apply hedge accounting, it should carefully consider each of these criteria. For example, when considering probability:

• Are partial or full prepayments likely to occur more rapidly than forecasted (e.g., when comparing historical prepayments to future expectations)?
• When prepayments occur, will it be possible to originate/purchase new assets with similar characteristics to replenish pool balances? For new originations, will floor strike rates be the same/similar to the existing assets in the pool?
• Will the swap include a sold floor to match/offset the floors in the assets?
• Is that a good deal economically?

Moving Forward

Below are three simple steps to remove risk from the general account by fixing the yield on a portion of floating rate assets:

• Query the asset database and aggregate floating rate assets by key characteristics (e.g., index, payment frequency, and floor rates) to see how large the pools are.
• Determine approximately how much hedging notional to trade and over what time period.
• Consider whether the entity has the hedge accounting expertise necessary to qualify for hedge accounting and to operate the hedge accounting over the life of the hedge. Consider downstream operating limitations in tracking assets throughout the life of the hedge and performing other supporting requirements, such as calculating effectiveness.

Chatham can help

Chatham Financial is an industry-leading expert on managing derivative portfolios of large insurers and asset managers. Through Chatham’s expertise in structuring a variety of hedging transactions and our depth of hedge accounting knowledge, we have helped clients efficiently and effectively structure trades that address both economic and accounting objectives. We can guide you through the process of pooling, help you navigate hedge accounting guidance, and enable you to operationalize your hedging program to convert floating-rate assets to fixed. We can also provide a technology platform to streamline your program and increase controls.