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I have heard that insurance companies make use of swaps and am just trying to get some clarity on that:

An insurance company (assume life insurance) has a fixed obligation to pay in the distant future (policy holder's death), ie. a substantial fixed lumpsum. For that the company receives from the holder (monthly) premiums (are these fixed or floating?).

How does it use swaps? If the premiums are fixed, then it could exchange those for floating with an interest-rate swap, but to what end? How exactly do they use swaps to manage their risk, and make a profit?

Thanks for any help provided

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2 Answers 2

Swaps are used

  • for hedging purposes against directional rates movements (insurance companies hold loads of fixed income instruments and are thus hugely exposed to overall rate levels, depending on holding period and portfolio turnover) and

  • to insure against inflation (insurance firms receive fixed premium payments),

  • to target portfolio duration

This is not an exhaustive list...

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In addition to what Matt Wolf pointed out, insurance companies use interest rate swaps to hedge certain liabilities arising out of their variable and indexed annuities business. It's somewhat dated, but this McKinsey report discusses those types of liabilities and how (if...) insurance companies hedge them.

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