We conducted several interviews with derivatives experts across EMEA markets about derivatives use in the insurance sector, to uncover how insurance firms are grappling with current market conditions, regulations, and business impact.

In insurance, derivatives are vital for managing risk, particularly in Asset-Liability Management (ALM). Life insurers rely on interest rate derivatives like swaps to address long-term liability exposure and use currency derivatives to hedge against FX risk. Credit default swaps (CDS) and equity options provide protection against defaults and market volatility, enhancing portfolio stability.

In life insurance, derivatives are crucial for managing complex products like Euro funds and variable annuities. Euro funds provide guaranteed rates and profit-sharing, transferring most profits to policyholders while leaving insurers with costs. Derivative use is common for in-the-money contracts but decreases for out-of-the-money ones as interest rates rise. Variable annuities offer income guarantees supported by derivatives, such as put options, to hedge against underperforming returns. This strategy reduces the capital needed for guarantees and aligns cash flows with liabilities.

Insurance companies face operational and regulatory hurdles in using derivatives, especially smaller insurers lacking resources and teams for complex adjustments like delta hedging. Hedging inflation is also challenging due to limited instruments, with swaps impacting returns. Under Solvency II, derivatives must focus on risk reduction and capital efficiency, limiting excessive risk via Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR). Additionally, IFRS 17 standards, introduced in 2023, may increase derivative usage to manage balance sheet volatility, though this need is still unclear given better alignment with market values.

In the EU, market volatility is pushing insurers to use derivatives for hedging against capital loss. Key trends include increased reliance on clearinghouses for OTC derivatives, which requires collateral and strains liquidity, particularly for smaller insurers, and the adoption of opportunistic strategies amid rising interest rates to secure high yields. This reflects a shift in viewing derivative-induced balance sheet volatility as “accounting” risk rather than economic risk. Overall, derivatives are essential for insurers to adjust portfolios in response to rising volatility from interest rates and geopolitical tensions. Given the increasing market changes and derivatives complexity, there is a growing need for high-quality derivatives data, accurate pricing, and innovative strategies.

 

Introduction

An insurance company’s primary business is to accept and manage risk while generating profit from this service. Insurers must meet their future obligations to policyholders; therefore, premiums are provisioned, and the investment strategy aims to manage:

• The ability to mitigate unexpected losses linked to insurance claims.
• The alignment of assets and liabilities, particularly for life insurance products with long-duration risks.
• The financial performance of the portfolio.

Insurers utilize a combination of financial products (such as equities, bonds, and real estate) that best match their portfolio risks and risk appetite.

Insurers also employ financial tools, such as derivatives, to refine their investment strategies over time and hedge against specific risks. Derivatives are commonly used by insurers as alternatives to traditional financial products, offering cost-effectiveness and liquidity. They provide flexibility in investment strategies and allow insurers to preserve cash for other operations. They are most used by life-insurance companies, given the long-term nature of their commitments to policyholders.

This study outlines (i) the primary use cases for derivatives in insurance with a focus on life-insurance companies, (ii) the challenges insurers face in using derivatives, and (iii) current trends in the EU along with a future outlook.

1. Use Cases for Derivatives in Insurance

Insurance companies employ derivatives for two main purposes:

• To meet commitments to policyholders by matching assets with liabilities.
• To hedge against market risks.

1.1 ALM Matching

Asset and Liability Management (ALM) involves matching cash flows between the insurer’s assets and liabilities to ensure the ability to meet policyholder commitments (e.g., paying claims or releasing funds from life insurance policies). Challenges arise from the inherent mismatch in duration, liquidity, types and currency between assets and liabilities.

In life insurance, liabilities often have long durations (e.g., annuities lasting over 30 years) and can only be matched with assets of shorter durations (up to 10 years for corporate bonds, 25 years for direct lending products, and 30 years for sovereign bonds). Very long-dated bonds are scarce resources.

Consequently, liabilities typically have longer durations than assets, creating a “duration gap.” Since duration correlates with sensitivity, market variations may impact the values of assets and liabilities differently if their durations and sensitivities are misaligned. Achieving a “perfect hedge” with traditional investments requires high-frequency trading; derivatives offer a more flexible option with lower operational costs, faster implementation, and tailored solutions for specific risks.

1.2 Hedging Risks (IR, Equity, FX, Credit)

Another significant use of derivatives for insurance companies is to hedge against market risks while managing asset and liability mismatches.

1.2.1 Interest Rate

Interest rate derivatives are the most commonly used by EU insurers, given that interest rate risk is the primary concern for portfolios with long maturities. These derivatives can take several forms, with swaps being the most prevalent (including interest rate swaps, swaptions, and forward-starting swaps). They can have very long maturities (up to 50 years) and are effective in increasing asset duration and closing the duration gap with liabilities. Insurers also use bond futures to hedge against interest rate risks. In mid-2024, with an expected decline in interest rates, insurers are hedging in-the-money guaranteed annuity options (GAOs) using interest rate strips.

Example: A European insurer may have long-term liabilities, such as life insurance policies, with maturities extending 20 to 30 years. These liabilities are highly sensitive to interest rate fluctuations due to their long duration. To cover them, the insurer holds a bond portfolio, which may include floating-rate bonds (e.g., linked to EURIBOR). However, floating-rate bonds have shorter durations, leading to a mismatch between the durations of the insurer’s assets and liabilities. As a result, the insurer is exposed to interest rate risk: a decline in interest rates would cause the value of its liabilities to rise more than the value of its assets.

To address this mismatch, the insurer might enter into an interest rate swap, where it pays a floating rate and receives a fixed rate, effectively converting its bond portfolio into fixed-rate bonds. This would extend the duration of its asset portfolio. All else being equal, fixed-rate bonds have longer durations than floating-rate bonds and are less sensitive to interest rate changes.

By using the swap, the insurer increases the duration of its assets, better aligning them with its long-term liabilities and reducing the overall sensitivity of its balance sheet to interest rate fluctuations.

1.2.2 Currency

Hedging against currency risks is another common use of derivatives for EU insurers, particularly for international investments or for insurers operating outside the Eurozone. Common derivatives for currency risk hedging include futures and forwards, with positions typically adjusted more frequently than for interest rate risks. Many insurers are currently automating their forex hedging processes. However, currency hedging is more complex for entities outside the Eurozone, often requiring a central legal entity to manage intra-group trades.

Example: A French insurance company has issued policies in the UK, with premiums and claim payments denominated in GBP. To mitigate its exposure to fluctuations in the GBP against the euro—and reduce the potential volatility of future cash flows in its reporting currency—the insurer may choose to enter into a currency forward contract. This would lock in an exchange rate for converting GBP premiums or claims into euros on specific future dates.

1.2.3 Credit

To protect against counterpart default risk, insurers frequently use Credit Default Swaps (CDS), which are also effective for addressing concentration risk in bond portfolios.

Example: An insurance company holds a portfolio of corporate bonds, with a significant portion issued by a single company, creating concentration risk. These bonds generate a steady stream of interest income, which is used to fund future insurance claim payouts. To hedge against the risk of the issuer defaulting, the insurer may purchase a credit default swap (CDS) on the bonds of that specific company.

1.2.4 Equity

Equity constitutes a portion of EU insurers’ investment strategies but can yield better returns under certain market conditions. Some insurers view it as a diversification strategy and may not hedge it. Others utilize listed put options to mitigate downside risk. Their simplicity and liquidity make them the most common derivative product for hedging equity risk. Other options include:

• Equity cliquets (collar strategy), especially in volatile market conditions to mitigate severe downside risk
• Equity forwards for hedging equity risk in Value-In-Force (VIF) assets to protect against potential market downturns

Example: An insurance company holds a significant amount of equity investments as part of its investment strategy, such as shares in a major stock index like the Euro Stoxx. These investments must retain sufficient value for the insurer to meet its liabilities to policyholders. Consequently, the insurer is concerned about the risk of a sharp stock market decline, which could reduce the value of its equity holdings and create a mismatch between its assets and liabilities. To hedge against this risk, the insurer may use derivatives like put options, which provide the right (but not the obligation) to sell assets at a predetermined price.

1.2.5 Customer Behavior Risk

Client choices also introduce risk, as policyholders have the option to redeem their contracts, akin to an “American option.” Under certain macroeconomic conditions, policyholders may withdraw more funds than anticipated, leading to liquidity risk (e.g., a life insurance contract with a guaranteed rate of 3% may prompt clients to withdraw if interest rates rise to 4%).

1.2.6 Positions and risks among OTC derivatives in 2023

We analyzed the over-the-counter (OTC) derivatives market for European life insurance companies operating in the American market at the end of 2023. This analysis is based on data from the National Association of Insurance Commissioners (NAIC Annual Statements – Sch DB), which represents the only global reporting on derivatives. The total notional amount at year-end 2023 is $200 billion.

 

Figure 1: OTC derivatives positions and positions by risk, 2023

Figure 2: Derivatives products, as % of the total notional amount of positions, 2023

 

Figure 3: Types of risks, as % of the total notional amount of positions, 2023

 

Interest rate is the main risk addressed by insurers with derivatives, representing half of the total notional amount in 2024. Within that, over 80% is composed of swaps, while 15% are forwards. On the other hand, Equity risk accounts for a third of the total notional amount of derivatives, with 75% of options, evenly split between purchased and written options, and a residual part of swaps. Credit risk constitutes 17% of the total notional amount, entirely composed of swaps. Last, FX is marginal at only 2%, also entirely formed of swaps.

1.2.7 Exposure by maturity in 2023

When considering derivatives exposure by tenor maturity, equity options are certainly utilized as a short-term hedging instrument (up to a maximum of 2 years), whereas swaps exhibit a longer tail.

 

Figure 4: OTC derivatives total exposures by maturity date year, 2023

 

Figure 5: OTC derivatives total exposures by expiry (maturity – trade date), 2023

 

A total of $40 bn of interest rate swaps will mature or expire in 2028 (fig. 4 above), corresponding to a high number of contracts with a 5-year tenor (fig. 5 above). A maturity of 5 years is within the common range for corporate and institutional swaps, as many bonds and loans are issued with similar maturities. Many interest rate swaps in the U.S. indeed fall within this medium-term range. These derivatives may have been exchanged in late 2022 or early 2023, subsequently to the sharp rise in federal interest rates starting in May 2022 (fig. 6 below).

We can also observe a large volume of shorter-maturity interest rate swaps expiring in 2024 and 2025, likely to have been exchanged at the beginning of the hike in interest rates, when its severity was uncertain.

 

Figure 6: Federal Reserve interest rates, October 2021 to December 2023

 

 

1.3 Common usages in Life Insurance Products

Insurers’ use of derivatives is driven by the complexity of their products, particularly in the life insurance sector. Additional options and embedded guarantees in contracts complicate risk management, making derivatives an attractive solution. For instance, Euro funds and variable annuities illustrate this complexity.

1.3.1 Euro Funds

Common across Europe, these products feature a guaranteed rate and additional profit-sharing, typically set between 85% and 100% in some regions. Consequently, when insurers use derivatives to generate gains, most profits are transferred to policyholders, leaving insurers with only the costs of using the derivatives. Derivatives for Euro funds are primarily utilized for in-the-money contracts (e.g., a guaranteed rate of 4% in a 1% interest rate environment). Their use diminishes for out-of-the-money contracts, where the incentive for better performance is limited. The recent rise in interest rates has led to decreased derivative usage in Euro funds, except in regions where profit-sharing is not standard, such as the UK.

1.3.2 Variable Annuities

Recently introduced in the European market, variable annuities are more complex than Euro funds. They combine investment opportunities with specific guarantees, allowing policyholders to invest in various assets while guaranteeing a minimum income. At the designated time, the accumulated capital is redeemed as income for the policyholder, aligning cash flow with liabilities. The guaranteed income can be increased annually through a ratchet mechanism based on the insurer’s active management of the fund. If the capital is insufficient to cover the promised income, a built-in guarantee compensates for the shortfall. However, this product entails significant market risk, as promised payments may differ from asset returns. Therefore, insurers use derivatives to manage these products, reducing the capital needed to back guarantees and hedging associated risks, commonly employing put options when market returns fall below guaranteed rates.

2. Challenges Faced by Insurance Companies

Implementing derivatives in an insurer’s strategy presents challenges, mainly related to product operability.

2.1 Technical and Operational Challenges

2.1.1 Technical Capability

Smaller insurers often lack the resources to implement derivative hedging. Developing and maintaining a dedicated team and tools is a significant investment that poses hiring and retention challenges. Some insurers opt not to implement derivatives due to regulatory constraints or stress from market volatility. Moreover, the time required to establish new derivative instruments can hinder the timely market entry of related insurance products. Organizational challenges, such as disconnection between investment teams and actuaries, can also impede progress.

2.1.2 Hedging Frequency and Delta Hedging

In asset-liability matching, “delta hedging” refers to a derivative’s price sensitivity to changes in the underlying asset’s price. Insurers can neutralize this risk using option contracts. However, delta hedging requires continuous and complex adjustments, which can be costly and deter insurers from utilizing derivatives.

2.1.3 Hedging in an Inflationary Context

While inflation-indexed contracts are rare, insurers are affected by inflation on their costs. Some regions, like Denmark, offer inflation-linked bonds, though not in sufficient quantities. Most insurers resort to inflation-linked swaps as a solution, making it challenging to hedge against inflation without adversely impacting returns.

2.2 Regulatory Constraints

2.2.1 Solvency II Qualitative Requirements

The use of derivatives in the EU is regulated under Solvency II. According to this standard, derivatives must adhere to the Prudent Person Principle, meaning their use should contribute to risk reduction, such as hedging or offsetting anticipated risk exposure (interest rate, currency, equity, credit risks) or facilitating efficient portfolio management. The European Insurance and Occupational Pensions Authority (EIOPA) oversees the monitoring of derivatives use by insurance companies.

The European regulator enforces limitations on derivatives, particularly concerning portfolio management efficiency and prudence:

• Derivative use must align with risk management objectives and procedures.
• Insurers must demonstrate that their derivative use for portfolio management efficiency does not disrupt the balance of quality, security, and liquidity.

In essence, derivatives cannot be used for portfolio leveraging or exposing the portfolio to unforeseen risks or speculative activities.

2.2.2 Solvency II Quantitative Requirements

European insurers under Solvency II must maintain two ratios:

• Solvency Capital Requirement (SCR): Sufficient capital to cover unexpected losses at a 99.5% confidence level for extreme losses over a year. The SCR is designed to cover all risks associated with the insurer’s activities:
  • Market risks: interest rates, equities, real estate, credit, foreign exchange
  • Counterparty risk: the risk of default from reinsurers, intermediaries, and policyholders
  • Underwriting risks linked to product types
  • Concentration risk
  • Operational risk
• Minimum Capital Requirement (MCR): Calculated above a set floor for each insurance or reinsurance activity, not falling below 25% or exceeding 45% of the SCR.

Derivatives can be used to guide solvency capital management (also called “tactical asset allocation”). However, their use may impact the calculation of the SCR and MCR ratios by introducing higher volatility and affecting net income, thereby limiting insurers’ capacity to take excessive risks on financial instruments, which could jeopardize their capital requirements.

2.2.3 IFRS 17 Implementation

As of January 2023, IFRS 17 replaced IFRS 4 as the accounting standard for insurance contracts, requiring insurers to measure the value of their insurance contracts, which can induce volatility on their balance sheets. By 2024, it remains uncertain how IFRS 17 will influence derivative use among insurers. This new standard may lead to more frequent adjustments of liability values based on economic conditions, potentially increasing derivative usage. Conversely, the closer alignment of accounting value to market value may reduce the need for derivatives.

3. Trends in the EU and Outlook on the Near Future

In summary, market volatility is the primary driver for insurers to engage in derivatives trading. They tend to prefer options to avoid capital loss in volatile markets. Two key trends have emerged:

• Following the 2008 crisis and the introduction of Solvency regulations, the use of clearinghouses for trading OTC derivatives has increased.
• More recently, the rise in interest rates in 2022 has led to the emergence of new opportunistic strategies reliant on derivatives.

3.1 Increased Use of Cleared OTC Derivatives

Trading derivatives involves counterparty risk associated with the potential default of the other party before contract settlement. In the EU, this risk can be mitigated through clearinghouses, which act as neutral counterparties. Insurers and trading entities are required to collateralize their positions to ensure solvency at maturity. Consequently, insurers must deposit initial and variation margins based on the underlying asset’s volatility. When the market value of a derivative contract declines (or increases), insurers must pay (or receive payment from) their counterpart, creating liquidity risks associated with derivatives and affecting SCR calculations. Additionally, the collateralization requirement may pose challenges for companies with lower assets under management.

3.2 Rise of More Opportunistic Strategies

While derivatives introduce volatility to insurers’ balance sheets, many choose to limit or prohibit their use, particularly among listed companies where negative variations could impact stock performance and necessitate explanations to investors. Conversely, new strategies are emerging alongside market volatility. Some players view financial statement volatility as “accounting volatility” rather than “economic” and favor derivatives. Notably, some players capitalized on the 2022 interest rate rise by locking in high rates for investments with derivatives, anticipating a future decrease in rates – a strategy that few traditional insurers can replicate.

4. Appendix

4.1 Notable Regional Differences within the EU

As of December 2023, the use of derivatives by European insurers is concentrated in a few countries (based on the value of derivatives in insurers’ balance sheets, in € billions): Denmark (€98b), the Netherlands (€48b), Spain (€21b), France (€14b), and Germany (€7b). Denmark and the Netherlands also have the highest ratios of derivatives relative to total assets.

 

Figure 7: Derivative amount (€bn) and share of derivatives in the balance sheet of EU insurers, by country (EIOPA, Q4 2023)

 

 

4.1.1 Denmark

Denmark’s appetite for derivatives grew in the early 2010s, spurred by the devaluation of the Swiss franc, which pressured the Danish crown. Danish pension funds engaged in trading against the Danish crown as part of their risk management strategy until the Danish National Bank prohibited this practice, compelling Danish companies to hedge in euros instead. Consequently, hedging against foreign currencies exposes Danish companies to double risk (hedging in euros and again in crowns).

4.1.2 Netherlands

The Netherlands has a historically complex financial culture, including in insurance, which partly explains the higher derivative usage compared to other EU countries. High guaranteed rates on life insurance policies necessitated more hedging through derivatives. Since the 1990s, other EU countries, such as France and Germany, have gradually lowered guaranteed rates, while Dutch companies have maintained them for competitive reasons. Pension funds dominate the Dutch market, particularly with defined benefit portfolios of long durations (pension premiums are invested once retirees begin receiving payouts). These Dutch pension funds are not regulated under Solvency II, allowing them to under-hedge against interest rate risks. The 2022 interest rate hike proved beneficial for them.

 

4.2 S&P Global Market Intelligence Derivative Solutions

S&P Global Market Intelligence offers a flexible and scalable derivatives service suite to handle regulatory requirements and investment decisions along the insurer’s full life cycle, enhancing their wider asset and liability management (ALM), risk management and capital management frameworks. We leverage our high quality, accurate, transparent and independent cross-asset service with extensive coverage. S&P Global Market Intelligence solutions support insurance companies to shift from using the standard formula to an internal model, as well as helping to improve the process.

Our OTC Derivatives Data (OTC DD) service provides access to multi-sourced curves and implied volatilities spanning over FX, Interest rates, Equities, Credit and Commodities. It provides a unique, high quality, independent ongoing and historical cross-asset derivative dataset, starting from 2007, covering the full spectrum of skew and tenors. Our deep coverage helps insurers to improve the calibration of reliable scenarios (real world, risk neutral and ESG) and fit pricing parameters to a bigger coverage of non-observable prices. Uses cases are i) in curve fitting model, insurers can calibrate their equity implied volatility risk factors on ATM options and skew across a wide strike range and long dated maturities, ii) in LSMC, fitting model parameters for ESG simulations (e.g., SABR) on the whole skew of swaptions, and iii) for historical stressed scenarios for capital add-on purpose. SPGMI OTCDD volatility surfaces are calibrated from a blend of exchange information and market-maker consensus information for best quality, transparency and the deepest coverage possible.

For more information, see our web site:
OTC Derivatives Data

Our Portfolio Valuations (PV) service helps insurers in their full valuation of derivatives, structured products and illiquid securities. Our service computes valuations i) using shocks defined by the Solvency II standard formula, ii) as input of scenario points of the fitting function (curve fitting model, LSMC), and iii) for stress testing purposes, with the flexibility to set up ad hoc scenarios at the client’s convenience. It provides independent valuations for a wide range of vanilla and exotic derivatives across multiple asset classes, under a range of stressed scenarios, as well as positions in a range of cash securities covering FX, Interest rates, Equities, Credit, and Commodities.

For more information, see our web site:
Portfolio Valuations

Our derivative solutions, including OTCDD and PV services, can further help clients in the price discovery process, with the aim of anticipating trends and exploiting market opportunities in the context of derivatives hedging, capital optimization, asset and liability management, and strategic asset allocation. Insurers can leverage high quality and accurate levels of IR yields as insights to anticipate market movements in the duration matching process. Furthermore, widely skewed volatilities help CIOs in their investment decisions for derivatives and for capital optimization.

4.3 Accuracy presentation and advisory services in Insurance

Accuracy is a wholly independent international consulting firm providing advice to company management and shareholders for their strategic or critical decisions, notably in transactions, disputes and crises.

Accuracy’s strength is to connect strategy, facts and figures. Our teams are international and multicultural, combining various skills to provide bespoke services to our clients. We recruit our consultants from the best.

Accuracy is present in 14 countries in Europe, North America, Asia, Middle East and Africa and leads engagements all over the world.

Through its expertise in the Financial Services Industry, Accuracy empowers finance leaders to navigate complex transformations and drive sustainable growth.

In the insurance sector, Accuracy covers three main situations:

• Strategy and business performance:
  • Accuracy supports insurance executives in making critical strategic and financial decisions, including optimizing performance, and identifying new growth opportunities.
  • Leveraging advanced data science and artificial intelligence, Accuracy offers tailored tools to help insurers analyze data, gain market insights, and make informed decisions that boost competitiveness.
• Transactions:
  • Accuracy advises insurance companies and investors on transactions, including divestments, complex carve-outs, business plan development, and synergy quantification.
  • Accuracy delivers independent valuations of insurance businesses, portfolios or assets, providing expert opinions for strategic investments (fairness opinions, management packages, etc.).
• Disputes:
  • Accuracy combines expertise in economics, finance, strategy, and accounting to provide objective, well-documented opinions in complex disputes involving insurers, across all markets and jurisdictions.

 

 

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Alix DUPUY – Director – Financial Services Industry – Accuracy

Enrico PICCIN – Director – EMEA Business Development, Derivatives Services – S&P Global Market Intelligence