PROFESSIONAL CLIENTS ONLY
Insurers underwriting risk in multiple currencies have, in the past, not needed to think twice about matching assets by currency. Historically, examining alternatives to the status quo hasn’t been beneficial enough to pass even a simple cost-benefit review, particularly for insurers with relatively small foreign currency exposures. However, in the current environment of ultra-low and even negative bond yields, this is no longer a no-brainer for insurers and certainly worth a closer look.
Most insurers wouldn’t consider holding unhedged foreign exchange (‘FX’) positions due to a combination of punitive Solvency II (SII) FX capital charges, and the economic risk that exchange rates move against the insurer as liabilities come due. However, each set of circumstances is unique and a one-size-fits-all approach simply doesn’t work.
In this case study we briefly explore the implications for insurers considering holding GBP assets against non-GBP liabilities and what options are available for actively managing that risk. This case study is presented in the context of work we have done for an insurer exploring these very questions.
We’ve recently worked with a UK insurer holding short-dated liabilities across a range of currencies. The base currency was Sterling and that was reflected in their investment portfolio which was entirely allocated to Sterling assets. This mismatch was starting to have an impact on their SII capital position and creating internal problems around underwriting performance reporting.
Our team worked through a potential asset liability matching (ALM) exercise to find appropriate assets to match liability currency, duration and liquidity profile in line with the insurer’s risk appetite. The insurer’s risk appetite was translated into a set of investment guidelines and it was clear that for certain currencies most assets that met the investment guidelines as well as provided aggregated cashflows that matched the liabilities were negative yielding. Consequently, we set about exploring alternatives to these negative yielding assets. The alternatives suggested needed to meet certain criteria, namely:
01 Needed to maintain an average credit rating for the overall portfolio of greater than A+.
02 Limited to only fixed income assets.
The global fixed income market remains a market divided by currency. The largest universe of investment options is the one available to US Dollar investors with UK & European fixed income investors restricted to a much smaller set of options. What’s more, with negative yields across much of the European fixed income market, investing in these smaller markets can be challenging for insurers.
For our insurer, the currencies in question were the Swiss Franc (CHF), the Danish Krone (DKK) and the Swedish Krona (SEK). As you might expect, the universe of eligible assets under the insurer’s investment guidelines to match these liabilities was, on average, negative yielding (in the range of -0.5% p.a. to -0.8% p.a.). Having discussed the project in detail with the insurer, it was clear there were three options available:
- Option 1: GBP Buy & Maintain
- Option 2: GBP Buy & Switch
- Option 3: Pure matching