-- this article authored by Kyal Berends and Thomas B. King
Insurance companies serve the important economic role of helping businesses and households to insulate themselves against risks. But these risks do not disappear from the economy - they remain on insurers' books, necessitating careful risk management among insurers themselves. Over the past two decades, one way that insurers have managed risk is through the use of derivative contracts, which derive their value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. Some of the more common derivatives include forwards, futures, options, and swaps. Most derivatives, including interest rate swaps (IRS), have historically been traded over the counter (OTC) rather than centralized exchanges.
The use of derivatives comes with its own set of costs related to the transaction, management, and collateralization of positions. With the implementation of the Dodd - Frank Act of 2010, those costs seem certain to rise. Among other provisions, the law requires the central clearing of certain types of OTC derivatives and mandates that those transactions must satisfy margin requirements that will in most cases require counterparties to post more collateral than was previously the case.2 Forthcoming rules will impose additional collateral requirements on derivatives positions for which the central clearing mandate does not apply. Thus, the new rules for both cleared and noncleared derivatives could generate new costs for insurers or require changes in their business practices.
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