Europe’s insurers might soon feel that they have been taking liquidity for granted. Regulatory and market changes that affect derivatives are pushing things to a point where the challenges for insurers in sourcing and posting collateral for trades cannot be ignored. 

 

The European Market Infrastructure Regulation (Emir), which aims to push derivatives trading into central clearing, is set to bring about wholesale change. But, even before Emir comes into force, many insurers have rewritten swaps agreements with banks in recent years in ways that reduce the assets they can post as collateral. 

 

At the same time, other elements are also forcing firms to reassess collateral requirements, such as parts of the Solvency II Directive, the prospect of an interest rate spike and the trend among insurers to invest more in illiquid assets. 

 

Banks and asset managers are on hand with ideas to help upgrade assets or secure access to collateral when needed. But traditional approaches to collateral transformation face constraints as a result of changing bank regulation. There are questions about the capacity of banks to continue providing collateral transformation services without adjustments to their business model. Some are starting to talk of forging partnerships with cash-rich buy-side organisations as they search for a workable approach to continue providing services that insurers, and others, rely on. 

 

Europe’s insurers might not be feeling the pinch just yet. But it is clear that the management of liquidity risk will take place in a fundamentally changed environment in future.

 

One trend that has contributed to the growing pressure has been for insurance companies and banks to replace old ‘dirty’ credit support annexes (CSAs) on Isda-documented derivatives with so-called ‘clean’ CSAs. These newer, narrower, CSAs limit collateral only to cash and government bonds in the currency of the underlying derivative. Clean CSAs are a good thing when insurers are net receivers of collateral, which has been the case for several years due to low interest rates. But that position will  reverse when rates rise again.

 

At the same time, appetite for higher-yielding assets such as credit, infrastructure, property and loans, is leading insurers to increase their holdings of assets that are ineligible as collateral both under new-style CSAs and the upcoming Emir regime. Aviva and Legal & General (L&G) are two examples of European insurers that have established commercial finance arms, and have been vocal in their desire to invest in long-term infrastructure projects. 

 

There are other pressures still to come. The inclusion of liquidity risk in the checklist for firms’ Own Risk and Solvency Assessment (Orsa) under Solvency II means insurers have to document this risk from this year on, with collateral pressures a key consideration. “Liquidity is a growing part of the Orsa assessment,” says David Prieul, head of the insurance and pensions solutions group in Europe at investment bank Credit Suisse, who is based in London. “We expect all regulators to highlight it as a potential risk that insurers must address,” he says.

 

Then there is Emir, which will force insurers to post initial and variation margin on derivatives trades when it comes into effect. The former will need to be high quality assets, but variation margin must be cash only. At present, insurers rarely post initial margin at all.  The full implementation of central clearing for insurers will not happen until mid-2016, but some trades after late 2014 will have to be cleared under so-called frontloading rules. Certain insurers are assuming that annuity business will qualify for a temporary exemption from frontloading that has been granted to pension schemes (until August 2015, but possibly to be extended). However, whether that will be the case is not entirely clear. Nor would an exemption apply beyond ring-fenced pensions business even if successfully secured. 

 

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