Japan’s insurers, and life insurers in particular, may have to increase their capital base, while aligning their asset portfolios more closely with the risk-return regime mandated by the ICS framework.
This will mean engaging in more pro-active asset-liability management. Indeed, many insurers may already have started doing this.
Once an ICS-style regime is introduced, insurers will have to consider not only the risk and expected return of the overseas asset, but the cost of capital required to support it
Here are some thoughts on managing market risk:
Asset-Liability Duration Mismatch
European insurers have been gradually lengthening assets to reduce duration mismatches against their liabilities, since Solvency II came into force in 2016. However, a shortage of longer-duration assets has hampered progress. That said, the use of alternative types of debt, such as long-duration infrastructure debt, offers a potential solution.
Unfortunately, there is a global shortage of ‘insurer-friendly’ infrastructure debt. Competition from global insurers and pension funds has compressed yields for this asset class, although it does remain attractive to insurers for diversification and duration purposes.
Where suitable assets don’t exist, or are difficult to access, an alternative approach may be suitable. By combining shorter-dated investments with derivative strategies designed to mitigate, or even remove, asset-liability duration mismatches, an appropriate level of duration-matched return may be possible.
Please see our Asia Pacific Insurance Survey for more information on recent Asian insurance asset allocation trends.
Long-Term Interest Rates
Very long-term savings products with investment guarantees are still the staple product of Japanese life insurers. The extended duration of the liabilities associated with these products, sometimes up to 30 years, helps explain why Japanese insurers have found it difficult to source assets long enough to match their liabilities.
As Japanese government bond yields have fallen with Japan’s slowing economy – yields are often negative for durations up to 10 years – Japan’s insurers are finding it increasingly difficult to honour investment guarantees. If the long end of the yield curve was to fall even further, additional capital would be needed to help pay for the guarantees already sold. Alternatively, hedging strategies involving the use of interest rate and equity options might be used to help manage guarantee costs in a declining interest rate environment.
As growth in developed economies continues to slow, and the investment returns needed to pay for Japan’s life insurance guarantees have become increasingly out of reach, the only real solution may be to develop alternative products – those without explicit investment guarantees. These are more akin to wealth management products and represent an emerging trend throughout much of the rest of Asia.
Both life and non-life insurers favour investing in equity-type assets. This is because they often generate the highest long-term returns in investment markets. Life insurers invest in equities to help pay for long-term investment guarantees, while non-life insurers invest to supplement the underwriting profits on their core insurance protection business.
However, equities are volatile and can require much more risk-capital in modern ICS-style regimes than they do within less risk-sensitive regimes. Japan’s insurers have relatively large exposures to equity risk and may not have enough capital to cover these risks once an ICS-style regime is implemented. They may have to sell out of this favoured asset class, reducing expected long-term returns, or they may need to hedge these equity risks.
One approach that has found favour in Japanese and European insurance markets is the use of sophisticated, systematic strategies to hedge equity risk. Implementation varies from firm to firm, but in a typical strategy, long-term put options are purchased to provide protection against share price declines, while shorter-dated call options are sold to help pay for the cost of buying puts. This so-called ‘collar’ strategy is designed to reduce economic risks, and hence risk-based capital requirements, while minimising expected hedging costs.
However, insurance regulators can be sceptical about the effectiveness of such collars, especially those that depend on asset manager discretion during times of market stress. They may not recognise the reduced risk-based capital requirements collar strategies are designed to achieve. One solution may be the use of more sophisticated rolling collar strategies that are implemented using frequent derivative trades that follow systematic rules, without asset manager discretion. These strategies are often more acceptable to regulators because they are less susceptible to human emotion and error.
Systematic approaches require advanced use of technology and are discussed in more detail in our insurance technology article.
Japan’s insurers, and especially life insurers, have been investing overseas in search of higher returns. Overseas investing is often tactical and driven by the returns available, net of the cost of three-month duration currency hedges. At the end of each three-month period, if the hedged overseas returns are no longer attractive on re-hedging, the insurer will usually divest and search for another overseas asset where the hedged returns are more worthwhile. Or the insurer may simply consider investing without hedging.
However, under ICS-style risk-based regimes, in order for the currency hedge to be fully recognised as a true risk mitigant, the hedge needs to have an outstanding duration of at least one year, or be implemented in such a way that the firm and regulators are confident that the strategy can be reliably renewed and maintained throughout the year. Otherwise, the effectiveness of the hedge is reduced in proportion to its outstanding duration. For example, a hedge with outstanding duration of three months would be considered to hedge only 25% of the associated currency risk.
Japan’s insurers are exposed to relatively large amounts of currency risk as a consequence of only partial, or possibly no, hedging of the currency risks associated with their overseas assets. Once an ICS-style regime is introduced, insurers will have to consider not only the risk and expected return of the overseas asset, but the cost of capital required to support it. It seems likely that in order to maintain overseas exposures at current levels without holding increased levels of risk capital, Japanese insurers will have to implement more sophisticated, and potentially longer duration, currency hedging strategies. As a consequence, overseas investing will become even more challenging for Japan’s insurers.
Hedging of overseas assets is a big issue for Asian insurers, in general, and is discussed in more detail in our Asia Pacific Insurance Survey.