05 June 2012

Risk.net: Targeting currency risks

European financial regulation does not move fast. Three years after the European Commission passed Directive 2009/138/EC, adding Solvency II to its regulatory framework, policy-makers continue to assess its potential impact on the European (re)insurance sector. Although the new rules and protracted consultation are primarily concerned with capital adequacy, regulators have taken a particular interest in how foreign exchange movements can impact firms’ asset liability management (ALM).

“For the first time, Solvency II imposes a specific capital charge on currency mismatches between the assets and liabilities of insurance companies. While sudden shocks in the base currency might net off across the balance sheet to some degree, insurers now have to look directly at those mismatches, figure out their potential losses and hold capital against those losses”, explains James Wood-Collins, chief executive at Record Currency Management (CM) in London, which currently manages £16.4 billion in client currency exposures.

EIOPA also noted in QIS 5 that effective currency risk management can reduce the amount of capital insurers will be required to hold, and imposed a set of conditions and reporting criteria firms must meet to qualify for relief. Counterparties must be rated at least triple B, with further relief available for collateralised exposures. “An insurer must be able to demonstrate to regulators that it has a well-established, documented programme in place to qualify for full capital relief for one year. This includes providing thorough analysis of trading costs and capital charges related to counterparty exposure”, says Wood-Collins.

While this might sound an attractive opportunity for currency managers to extend their forex overlay customer base beyond the pension fund realm, insurance consultants argue that uptake could prove limited. In the UK for example, the Financial Services Authority (FSA) currently monitors insurers’ ALM practices, including their currency mismatches, while foreign regulators typically require insurers to hold currency reserves in the foreign jurisdiction to cover foreign liabilities.

Notwithstanding uncertainty on liability exposure, managers argue that an external currency manager can bring tangible risk management benefits for insurance clients on a range of issues.

Beyond traditional forward-roll strategies, however, managers say dynamic hedging programmes using forex options and other derivatives can allow clients to benefit from market upside when the currency movement is in their favour. “There is increasing awareness among insurance companies that static hedging programmes can lead to suboptimal risk management outcomes. These firms are open to looking at a more dynamic approach”, says Arnaud Gerard, senior vice-president at Pareto Partners in London, which manages $50.5 billion (£31.4 billion) in currency overlay and absolute return strategies.

For now, uncertainty over which forex products will fall under the new rules is another reason for clients to put off making significant changes to their hedging activities. “The final regulation [Dodd-Frank Act in the US, and EMIR in Europe] remains extremely fluid. At this point, it seems to be the case that forex options and non-deliverable forwards will move onto exchanges, with non-standard derivatives traded under collateral in the over-the-counter markets being subject to clearing requirements. However, if managing exposures to certain instruments leads to significant additional capital requirements, some insurers may review their use of those instruments or markets,” says Arnaud.

Faced with an array of new rules and greater scrutiny of how they manage capital and balance sheet risks, European insurers are under increasing pressure to reform governance and operations. Although large firms have internal resources to perform risk management functions, they can lack the institutional will to modernise. “Most of the insurance companies I talk to acknowledge the benefits of a dynamic hedging approach that promotes a more efficient use of capital, but many lack the governance or skills to do it themselves. After a first phase of observation, we may see some of the more capitalised insurers dedicate more resources to dynamic hedging”, says Gerard.

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