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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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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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Here is another application. Suppose, an insurance company faces a wave of unexpected policy claims and issues floating-rate bonds to cover these claims. To reconcile the floating-rate receivables and fixed-rate payables, it purchases IR swaps.

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An interest rate swap can be regarded a combination of a floating-rate and a fixed-rate bond, with off-setting notionals:

  • Pay-fixed IRS: we are short the fixed-coupon bond and received the variable-coupon bond. Since floating-rate bonds have very low duration (i.e. low sensitivity to changes in rates), being paid IRS means being short duration.

  • Receive-fixed IRS: we are long the fixed-coupon bond and short the variable-coupon bond, meaning that we're long duration.

Insurance companies constantly try to balance the duration of their portfolios to be approximately duration neutral: i.e. they have long-dated liabilities, typically with very high duration and high convexity. When the rates (even implied rates) change a little bit, the insurance companies will need to rebalance the duration of the portfolio (which changes when rates change, due to the convexity of the long-dated liabilities). They would use IRS based on the formula described above, i.e.:

  • I need to increase duration => I receive fixed IRS

  • I need to decrease duration => I pay fixed IRS

Portfolio of mortgages is duration-hedged the same way (i.e. using IRS).

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