Asian insurers hedge away solvency fears

Asian insurance companies have sat up and paid attention to their solvency ratios during the past two years like never before. This has led to unprecedented levels of derivatives take-up. But will this conversion to derivatives last? Harry Thompson investigates

The wild equity and bond market price swings in 2008 and early 2009 left the solvency ratios of many insurance companies in the Asia-Pacific region in tatters, as asset portfolios devalued and low interest rates made liabilities expensive. Regulators in some jurisdictions began to ask for weekly reports on solvency positions and, as capital positions looked precarious, the threat of government takeovers loomed (as happened to two small Taiwanese insurers, Walsun Insurance and Kuo Hua Life Insurance in January and August 2009 respectively). Traditionally conservative insurance companies, meanwhile, were forced to take up derivatives hedges to keep their solvency ratios intact, so helping them to avoid a similar fate.

Solvency ratios and asset liability management (ALM) considerations are still weighing heavily on the minds of senior insurance executives as they continue to review their positions post-crisis and look for new ways to manage them. And this has led to a broad change in hedging practice alongside the increased use of derivatives strategies.

The proposition of Asian insurers hedging and rebalancing their portfolios has been an attractive one for banks, with several having built up ALM coverage in the region. Concurrently, some insurers are building regional risk management teams, with the UK’s Prudential, for example, even establishing a dedicated capital management role for the region – before it unveiled plans to buy American International Assurance.

Reasons for the shift in strategy are varied. But the main driver that is pushing more hedging is the increased capital allocation required against unhedged risks, according to Amit Agarwal, Hong Kong-based managing director for rates structuring, Asia Pacific, at Barclays Capital. Raising capital is now more expensive than before, meaning that proactive risk management and an efficient use of regulatory capital is becoming critical. “Insurance companies are realising that capital is a scarce commodity,” says Agarwal. “Whether international or local, the trend is the same – everybody now looks at capital as a scarce commodity.”

Agarwal believes this shift to more holistic hedging and capital management is part of a long-term trend. “This is ongoing, not one off. It will continue over months and years, with a continued heightened awareness… there is likely to be far more involved hedging than what we used to see a few years back,” he says.

Peter von Richthofen, a director in Deutsche Bank’s strategic transactions group in Hong Kong, says before the financial crisis, multinational businesses seeking to grow in the region would originate the money from head office. “Now the head office tells them to try to originate it locally first,” he says. “You won’t get the capital to grow from the group as easily as you would before.”

Barclays Capital’s Agarwal adds that tighter capital requirements necessitate insurers to hold more capital for the risks they are taking and that the risk to capital markets is the most significant source of risk they face. “Therefore, hedging the risk to capital markets will allow insurers to allocate their capital more efficiently, for example, releasing the capital they are holding for interest rate risk and use that to grow new business,” he says.

New business growth will typically entail additional capital requirements under local (in-country) solvency rules, under home market solvency rules for multinational insurers and under the insurers’ internal economic capital model, where insurers apply it. While capital requirements under European Union and US home market rules can often be higher than the local capital rules in many local Asian markets, the size of this differential can vary depending on where the insurer holds the capital, according to Von Richtofen, who adds that international insurers are increasingly trying to hold only the necessary capital for specific markets. “There is a distinct change in tone. Historically, insurers focused purely on their home market and internal models; they simply didn’t care about local rules,” he says. “[Now] firms must hold the right amount of capital; they can’t waste it.”

As an example, let’s say the Asian subsidiary of a multinational insurer has a local minimum risk-based capital (RBC) requirement of 100, based on the local market solvency rules. The insurer’s home market regulator does not recognise the local Asia RBC solvency regime as ‘equivalent’ to its own solvency regime, and so the regulator has to recalculate the solvency requirement for the Asian operation under its home-market solvency rules. The home-market solvency requirement for the Asian operation on a standalone basis might be 150. But, under the new Solvency II rules, the insurer can claim a diversification benefit in calculating the home market, group level solvency requirement – albeit this diversification benefit is dependent on demonstrating fungibility of capital.

The implication for the insurer is that it does not make much sense for the total capital required for the local operation, in this example 150, to be kept in the local operation: dependent on the exact market, moving capital out from the local market will often require local regulatory approval, meaning the capital would likely be considered as not fungible. This means the insurer is strongly incentivised to keep just the minimum amount of capital required under local solvency rules in the local operation (100), with the remaining 50 kept at group level, which can be hypothecated against the local operation. If the insurer can reduce capital requirement in the local operation, for instance through better ALM matching, then even better, says Von Richthofen.

There is a difference in exactly how international and domestic firms need to tackle their solvency management. Multinational insurers are driven more by their economic capital models defined by their head office, and to a lesser extent by local risk-based capital frameworks, “especially now with Solvency II in the headlights of all European players”, says Marco Hoogendijk, a director for fixed income structuring, at BNP Paribas in Hong Kong. Changes are also occurring at a domestic level, but driven more by the conditions of local regulatory environments.

Maintaining positions

Hedging activity directed at maintaining solvency ratios has in particular centred on interest rates, with a secondary concern being equity hedges. Interest rate strategies can be broken down into two types, either related to protecting against changes in interest rates, or to extend the duration of assets, to better match liabilities.

One of the biggest problems traditionally facing insurers in Asia has been this mismatch in durations of assets versus liabilities, with liabilities stemming from life assurance policies typically much longer dated than the available bonds insurers can buy. One trend during the past 18 months has been for insurance companies to buy long-dated interest rate swaps, or structures featuring these, allowing them to lock in the current or a certain level of interest, for as long a duration as possible.

“Things have changed a fair bit,” says one regional chief actuary for a major European firm, who declined to be named, adding that “before [the downturn] insurers were much more relaxed about the mismatch in duration”. Typically in Asia, durations on offer on bonds are relatively short compared with those available in other markets. For example, 50-year bonds are almost unheard of in Asia, but are a staple part of the US market.

As well as establishing durational matches, interest rate strategies help insurers to lock in higher interest rates long term. While interest rates in Asia are broadly expected to rise, there is always concern they could drop or remain flat, meaning returns on assets will remain poor. Bankers say insurers tend to buy hedges when approaching the insurance company’s target rate – insurers typically set a return benchmark based on the liability discount rate, which in many Asian markets is a fixed discount rate that does not reflect current market interest rates. These hedges may be added incrementally in tandem with rate rises. Zero-coupon swaps or notes, long-dated cross-currency asset swaps and inverse floaters are among the tools being looked at to extend duration. However, insurers have also started to mix in swaption strategies too, so that even in the event of interest rate rises they can still capitalise on the upside.

Away from interest rate risk, the next biggest risk is equity. Insurers in some jurisdictions, such as South Korea, have comparatively little equity exposure, while insurers in Singapore and Malaysia have historically had higher exposures. “Historically, insurers have tried to time the market, selling down when the market was cheap,” says Deutsche Bank’s Richthofen. He adds that many insurers sold down their shares before the big equity drops in 2008 and so were protected there, but retained only low exposure as the markets improved in 2009 and failed to capitalise on a broad 30% market rally. Market participants note that while some insurers had used equity crash hedges, the take-up in this area is still low. This meant that after markets stabilised later in 2009, insurers had to repurchase positions rather than keep exposure through the downturn.

“If they’d hedged rather than sold [when markets rallied], then they would have been long the market at the right time,” says Richthofen, who adds that Deutsche Bank believes this loss will change the way the insurers look at risk. “We’re seeing now much more interest in options-based hedging strategies [on equity portfolios].”

However, one concern all insurers have when doing derivatives trades with banks is counterparty risk, which makes them wary – although this risk can be mitigated, for example, with collateral posting under credit support annex agreements.

Questions over need

Insurers say while they have increased their usage of derivatives, in part due to solvency concerns raised by immediate regulatory requirements, they are unclear if they will maintain large derivatives positions in the future. One regional chief actuary for a European multinational, says activity is focused on building up what he calls “realistic positions” in terms of capital volumes and make-up, and that the consideration of solvency is just an overlay to that – suggesting the focus on solvency is retreating somewhat as markets recover.

“Banks always have ideas, but I’m not sure how much traction they get,” he says. “There’s a lot we can do ourselves – a lot you can do to manage your own risks first.”

Some locally focused insurers in the region highlight a preference for dealing with liabilities over assets to better balance ALM and meet solvency requirements, including selecting appropriate product mixes. “Addressing the liabilities requires you to understand the issue at the root cause, you need to know your customer needs, know your products, and suitability, instead of just creating products, selling, passing it on to risk management and saying, ‘here sort this out’,” says Lennard Yong, chief financial officer at ING Life Insurance in Hong Kong.

Patrick Cheah, chief actuary and appointed actuary of AmLife Insurance and president of the Actuarial Society of Malaysia in Kuala Lumpur, takes a similar line, saying for the time being his firm was looking at investment mixes and product mix, and the effect that altering these have on AmLife’s capital adequacy ratios. He adds that there are not that many derivatives hedging options available in Malaysia and the cost can be substantial, especially for a small insurance company.

Banks, however, say hedging uptake depends on the insurer in question’s capital position. In actuarial terms, if an insurer is undercapitalised, then they are at risk to market movements, and in this case it can still make sense to put solvency-related hedges in place. However, one problem here that is consistently raised by insurers is the cost of hedging, with one actuary saying, “what insurance is working through now is a trade-off between hedging and excess capital… there is more awareness of hedging [now], however”.

Added to the list, for public insurers, is that the potential demand for hedges on solvency really depends on the risk appetite of shareholders, which can vary from company to company – though it is notable that relatively few local firms in Asia are currently listed.

Insurers might determine their own solvency on a simple basis, for example, by asking ‘are we holding enough capital?’. Firms holding excess capital might not want to be hedging, say some, particularly if their capital is already adequate to satisfy the risk appetite, or risk aversion, of their shareholders, thus avoiding extra costs and dampening profits.

Duration mismatch hedges are also criticised on the grounds that duration risk is basically interest rate risk – but the hedges often only really protect for a small change in interest rates, rather than large or unusual rate changes as seen during the global financial crisis. This means that to use them effectively, an insurer must have a firm view on the direction and size of interest rate movements.

One international insurer based in Hong Kong, says while the tightness of capital was still a big driver of hedging, it might not be the case if capital were to loosen again.

“There may be some views that it is more cost effective to hedge when markets are good, rather than only put hedges in place when markets are bad [when they are even more expensive], so you may see some tail-risk hedging programmes. But in my view, it is more likely for insurers to put in place trigger points at which they would look to hedge, if markets did again deteriorate,” he says. “For example, with a solvency margin of 300% they might not hedge, but if it dropped to 200% they might be hedging.”

However, other market participants say lessons learned from the crisis are still very fresh in people’s minds. Moreover, increased regulatory scrutiny would continue to stoke demand alongside IPO activity expected in Asia this year. This means solvency is likely to be re-visited and perhaps toughened.

“Most of the [hedging] response to regulations come from the expectation of regulatory change, rather than changes themselves,” says Barclays Capital’s Agarwal, referring to both local and international regulatory change. “We believe the lessons learned from the crisis as well as the increased regulatory scrutiny on capital and risk management will have a long-lasting impact.” 

The benefits of a rate rise

One often overlooked aspect of interest rate rises – broadly expected across Asia this year – is that they are generally a relatively good thing for insurance companies in terms of managing their assets and liabilities. Although insurance companies are big bondholders – meaning that when interest rates rise, their portfolios could lose value on a marked-to-market basis – typically insurers regularly raise lots of money, meaning they can buy bonds at a higher rate. More importantly, says Geoffroy Wallier, head of global structuring for Asia Pacific at Royal Bank of Scotland in Hong Kong, insurance companies benefit from a higher discount rate on their liabilities when rates rise – an effect that is due to the current value of money.

The possibility of a rate rise could have a significant impact in some of the same jurisdictions where insurance companies for historical reasons have high liabilities. Examples include Taiwan, Korea and Japan, which are also broadly considered the jurisdictions where firms have the largest mismatch between assets and liabilities, because they are low interest-rate environments and correspondingly returns on asset investments are typically low. Analysts are expecting Korea and Taiwan’s interest rates to rise gradually throughout 2010, while Japan’s interest rate is likely to remain fixed at 0.1%.

Wallier says more favourable interest rates need not translate into a reduction in hedging, however. The mix of asset classes in their portfolios means interest rates are just one dimension. He adds: “It is true that interest rates are expected to rise, but the good risk managers will be thinking, ‘What will happen to my solvency ratio if the interest rates remain the same? What if the interest rates drop? Do I have enough capital if extreme scenarios happened? What is my appetite for this risk?’”

Regulation and solvency hedges

The Asia region has been in a state of regulatory flux regarding solvency ratios since before the global financial crisis. Historically, solvency requirements in Asia were based on the European Solvency I-style rules, which consist of a margin on life insurance reserves, typically 4%, plus a factor for insurance risk exposure.

Under these old rules, the solvency requirement was divorced from actual balance sheet risks, meaning the capital requirement for an insurer matching the liabilities with equities or government bonds is basically the same. But this is changing with jurisdictions gradually moving towards adopting more risk-based frameworks, typically similar to the risk-based capital guidelines issued by the US’s National Association of Insurance Commissioners (NAIC). Several have come into line already, the first being Singapore in 1995.

More recently, Malaysia adopted its own risk-based capital rules in 2008, and South Korea and Thailand are implementing theirs in the coming two years. Many other jurisdictions are still using Solvency I, including China and Hong Kong – the latter of which is said to be examining the possibility of a risk-based framework.

The financial crisis highlighted that the biggest balance sheet risk came from equity portfolios, with some parties speculating that Asian risk-based capital regimes probably undercharge for equity risks. Another substantial market risk was seen in long-dated credit risk exposures, with one market watcher saying that it is “notable that none of the Asian solvency regimes actually capture the term structure of credit risk”.

One potential feature for hedging in the region are hedges on solvency ratios themselves – complicated hybrid transactions that take into account both assets and liabilities, and something that has a basis in the mature European markets. “If you want to have an even more global view, you can even buy protection on your solvency ratios,” says Geoffroy Wallier, head of global structuring for Asia Pacific at Royal Bank of Scotland in Hong Kong. “Companies here are getting very interested in this right now, especially after the big falls in the market over the past year-and-a-half.”

Some, however, are sceptical of the need for solvency ratio hedges in Asia in the near future.
Peter von Richthofen, a director in Deutsche Bank’s strategic transactions group in Hong Kong, says while hedges of this sort might get traction in Asia, currently they may not be appropriate in higher growth jurisdictions. He notes that if the insurer enjoys high growth, then  “in two years its business may look totally different”. And some market watchers note that markets lack some of the basic tools for risk management to perform such deals.

Wallier says interest in the ratio hedges is currently coming from the more developed markets in Asia, citing Australia, Singapore and Hong Kong, although he says these ratios could apply to anyone. He also adds that these sorts of trades do not prevent the business from growing because they can be adapted, adding that their function was as a safety net in case of major market disruptions. “A safety net is always positive to have even if your business grows.”