How Asia insurers could use derivatives and alts to raise returns
Asian insurers who selectively employ derivatives to improve their asset and liability management (ALM) and invest more into alternative assets could unlock additional investment returns and help to raise their profits by a combined $3 billion over three to five years, say industry experts.
However, insurers seeking to do so will need to enhance risk monitoring procedures at the same time.
According to Angat Sandhu, head of consultancy Oliver Wyman's Asia Pacific insurance practice, Asian insurers could increase their profits by at least $3 billion over three to five years by optimising ALM. One way of doing so is by using exchange-traded and over the counter (OTC) derivatives on their long liability durations to take advantage of temporary interest rate mismatches.
For example, insurers that have a strong view that interest rates may increase soon could choose to keep the duration of their assets shorter than the liabilities to benefit from the potential rate increase, he explained.
He did not provide details on potential gains. However, Alberto Scarsini, a London-based director of Willis Tower Watson's insurance investment team, said any upside from derivatives will depend on the direction of the trade and market conditions. According to Adeline Tan, Mercer's wealth business leader for Hong Kong, derivatives could help to "provide smoother returns over time".
Insurance companies have traditionally used derivative instruments to manage and mitigate a variety of risks. However, more are employing them now not only to hedge against periods of increased market volatility, such as amid the pandemic, but also for income generation. In July, China's banking and insurance regulator also issued rules allowing insurers to participate in bond futures to help the sector hedge interest-rate risks.
"We are aware that insurers have been using derivatives for hedging for a while, with varying sophistication," said Tan. "We expect that they will continue to use derivatives and deepen their capabilities for selection and execution."
However, navigating the world of derivatives is easier in theory than in practise. Ironically the cost of insurance against volatility is rising. Tan said that "market pricing for derivatives for 'protective' strategies has become very volatile, and insurers' investment teams will have to work hard to find value".
Sandhu cautioned that specific regulations, which requires insurers to hold different amounts of capital against investments according to their perceived riskiness, could make duration mismatches more expensive, reducing the attractiveness of derivative strategies that could increase regulatory capital charges.
NEW RULES INCOMING
Insurers in the region are already having to deal with the transition away from Libor, new rules on the use of derivatives and changes in the adoption of risk-based capital regimes. Publication of the Libor benchmark is likely to cease at the end of 2021.
Several Asian countries are progressively implementing new rules on using over-the-counter (OTC) contracts. Hong Kong’s Securities and Futures Commission, for example, will phase in the initial margin (IM) requirements from September 1 next year. IM refers to collateral held to protect a counterparty to an uncleared derivatives contract from potential credit and operating losses.
Separately, governments in the region are at various stages of implementing capital regulations for insurers. In Japan, insurers are expected to adopt economic value-based capital standards in 2025. In China, Chinese insurance companies are gearing up for the launch of the second phase of the China Risk-Oriented Solvency System (C-Ross II).
As more countries move towards a risk-based capital framework, Sandhu noted that insurers in Asia have become increasingly interested in more sophisticated risk transfer transactions to optimise balance sheets. Risk transfer is another means of optimising capital. This can be achieved in several ways, including reinsurance, shifting policy ownership and transferring operations to another party; reinsurance agreements with a reinsurer outsourcing the functions to a specialist closed book manager, he noted.
In light of the various regulatory changes, Asian insurers would have to ensure sufficient liquidity and improve their risk monitoring. Scarsini noted that European insurers monitored their solvency and liquidity positions more frequently as they reassessed their hedging activities amid-Covid-led market volatility
"They reviewed their tools and records to ensure that their risks were properly identified, monitored and managed in line with their risk appetite and regulatory requirements," he said.
RISK IN ALTERNATIVES
Another way insurers could potentially increase risk-adjusted returns is by investing more into alternative assets.
The trend of insurers investing into areas like private equity, private debt, real estate and infrastructure has gained traction in recent years, but they should also do so with caution, advised experts. Sandhu said insurers' recent allocations to alternatives have generally ranged between 1% and 5% of their portfolios.
While insurers could invest more into private assets such as infrastructure, natural resources and private debt, they will need to manage the liquidity profile of their overall portfolio as they do so, said Sandhu.
"In the case of South Korea, we have seen insurers increasing their allocation towards alternative investments in the past few years," Eunice Tan, senior director at S&P Global Ratings told AsianInvestor. South Korea's National Health Insurance Service, for instance, said in April it plans to commit up to W1.4 trillion ($1.14 billion) to its first alternative investment.
"These assets often have longer investment duration and therefore match the long-dated liabilities. While the mismatch between assets and liabilities may narrow over time, the need to strengthen credit oversight on the inherent quality of these alternative assets will become more important," Tan said.