Among the far-reaching reforms included in the Dodd-Frank Act (the “DFA”) was a comprehensive new regulatory framework for derivatives. Title VII of the DFA authorizes the Commodity Future Trading Commission (“CFTC”) and the Securities Exchange Commission (“SEC”) to require that certain “swaps” (regulated by the CFTC) and “securities-based swaps” (regulated by the SEC) be cleared through a clearing organization as to swaps or a clearing agency as to securities-based swaps. The provisions of Title VII were effective as of July 17, 2011 except to the extent that regulations were required to implement a provision in which event that provision was not to be effective until 60 days after publication of the regulation. The SEC and the CFTC are gradually implementing regulations so the full picture of the new derivatives regulatory framework has yet to emerge.
On July 19, 2012, the CFTC published its final rule as to the so-called “end-user exception” that exempts certain non-financial counterparties which enter into swaps to hedge commercial risks from the clearing requirement. Insurers and reinsurers are not eligible for the end-user exemption. The CFTC and the SEC issued a joint final rule defining a number of terms including “swap,” “security-based swap” and “mixed swaps” on August 13, 2012.
Neither the SEC nor the CFTC has yet determined that any swap or securities-based swap is required to be cleared. In making a determination whether a swap or securities-based swap (or group of swaps or securities-based swaps) must be cleared, the two agencies are required to take into account a number of factors, including notional exposures and systemic risk. Any counterparty which enters into swaps and securities-based swaps that are required to be cleared will likely be subject to rules and regulations of the clearing agency, including margin and collateral requirements. Even derivative transactions that are not required to be cleared may be subject to reporting requirements, although neither the CFTC or SEC has proposed rules as to swap or securities-based swap reporting.
Insurers and reinsurers should monitor developments over the next year and be prepared to clear some and report all of their derivatives transactions. In the event that the CFTC or SEC requires clearing of a swap or securities-based swap that is part of the hedging strategy of an insurer or reinsurer, the value of the hedge provided may be reduced by the cost of meeting collateral and margin requirements of clearing agencies or organizations, clearing fees and other clearing expenses. Depending upon the scope of any reporting obligation, swap counterparties may either need to designate personnel to comply or contract with a third party, such as an existing investment manager, to submit required information.
While swaps dealers and the International Swap and Derivatives Association ("ISDA") and the Futures Industry Association ("FIA"), their industry organizations, are taking a wait-and-see attitude as to the specifics of the new regulations, it is in the interest of insurers and reinsurers to follow developments impacting the OTC derivatives markets. For example, FIA and ISDA have jointly released a cleared derivatives addendum and a cleared derivatives execution agreement addressing the clearing requirements of the DFA.
However, until clearing of a swap or securities-based swap is required or reporting obligations formulated, insurers and reinsurers may continue their current OTC derivatives investment practices without clearing or reporting.