Accounting For Derivatives Under General Accepted Accounting Pracices

As a firm with emphasis on risk management, we always advise our clients to hedge their portfolios in order to reduce the PnL volatilities.

However, recently Metlife, the largest insurer in the US, was hit by a $3.2 billion loss in derivatives that were used to hedge the rising interest rates, causing a $2.1 billion loss for the quarter overall.

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The loss thus brought up an issue: hedging to reduce the revenue volatility works only if the hedging and hedged instruments are at the same level of liquidity and the same accounting rule applies.

Leslie Scism pointed out that the problem is due to the marking to market of the derivative book under GAAP

In the long term, the rise in interest rates bodes well for MetLife. Few American industries are as hurt by low rates as life insurers, which invest huge sums of premium until the money is needed to pay claims. The money is typically invested in higher-quality bonds, so insurers’ profits have been pressured as they put new money to work at the ultralow levels in place since 2008.

MetLife’s results took a hit in the latest period because life insurers must mark their derivatives to market under generally accepted accounting principles. When rates rise, the value of the protection they buy to protect results from low rates falls. Read more

By contrast, Metlife’s liabilities appeared less volatile because the insurer used different assumptions and accounting rules to value their liabilities.

In short, when interest rates rose, the insurer suffered a marked-to-market loss in their derivative hedging book, while the gain in the liability part is not recognized immediately.

The values of both the hedging and hedged assets must be accounted for, but requiring companies to apply different accounting rules to hedging and hedged instruments is too punitive. This can discourage the risk managers to prudently hedge in order to reduce the revenue volatilities.

Maybe a change in accounting rules is needed?