Forward rate agreements in life insurance: A double-edged hedge

Forward rate agreements (FRAs) can help life insurers manage reinvestment risk—but without strong oversight, they may create more volatility than they solve.

This article is written by Rahul Khandelwal, Partner, Risk Consulting, EY India.

Co-authored by:

1. Varun Gupta, Partner, Risk Consulting, EY India.
2. Swati Umre, Partner, Risk Consulting, EY India.
3. Rajesh Dalmia, Partner, Risk Consulting, EY India.

In brief

• Life insurers are turning to Forward Rate Agreements (FRAs) to hedge interest rate risk on long-term guaranteed products.
• While FRAs offer flexibility and cost-effective hedging, they also introduce counterparty, liquidity and model risks.
• Effective Asset-Liability Management (ALM), governance and capital buffers are essential to ensure FRA strategies support, not strain, insurer solvency.

Benefits and Risks of Forward Rate Agreements

In the realm of increasing demand for long-term, non-participating life insurance—particularly for products offering guaranteed maturity values and surrender benefits—managing reinvestment risk is paramount. These are products where ALM is critical, and interest rate volatility can significantly impact the profitability and solvency of insurers. These guarantees are often priced with reference to 10-year government securities (G-Sec) yields. Given the inherent interest rate volatility, some insurers, within the boundaries of permissible regulatory frameworks, are utilizing FRAs as a tool for hedging future reinvestment risks. The FRA is an Over The Counter (OTC) derivative tool that is valued at mark to market for losses, only from a solvency perspective, as per the regulation, where insurance contract liabilities are valued at mark to market for linked liabilities but for others are at book value. Therefore, for non-linked liabilities matched with FRAs, the risk of solvency needs adequate risk monitoring.

The upside and the caution

FRAs can be an effective solution for locking in forward interest rates. However, like any derivative instrument, their utility hinges on responsible deployment, robust internal governance, and continuous tracking of hedge effectiveness. Without adequate safeguards, they may introduce unintended consequences.

The caution

1. Rate dislocation: If actual market rates deviate materially from the FRA-agreed rate, even a well-structured FRA can lead to unintended profit and loss statement and balance sheet impact; the economic hedge may underperform—especially where surrender value floors are dynamically adjusted to market benchmarks.

2. Counterparty exposure: A downgrade or default of the counterparty can impair capital position, with added implications under evolving risk-based capital frameworks.

3. Mark-to-market volatility: Rising rates can lead to valuation losses on FRA positions. These may reduce available capital and impact solvency margins, where liabilities remain relatively insensitive in the short term.

4. Liquidity pressures: In periods of market stress, mark-to-market calls can strain internal liquidity buffers or require sponsor-level capital injections.

5. Concentration risk: An over-reliance on FRAs, without a diversified interest rate risk strategy, can leave insurers exposed to policyholder behavior and basis risks.

6. Model risk: The internal models used to predict cash flows or interest rate movements may be oversimplified, making the FRA ineffective as a hedge.

When do FRA-linked risks become material?

The following scenarios may heighten risk materially: