Capital, risk and return: Putting derivatives to work in insurance portfolios

Derivatives as a solution

Insurers rarely make investment decisions based on return alone. Every allocation must be considered against liabilities, capital requirements, currency exposure and accounting treatment, and those demands do not always point in the same direction.

Derivatives can help reconcile them. Used within a disciplined framework, they allow insurers to adjust balance-sheet risks without continually trading physical assets. In practical terms, that might mean adding duration without adjusting a bond portfolio, hedging an overseas allocation, or limiting the downside from equities. All these approaches can alter the risk taken for a given amount of regulatory capital.

That flexibility has become more important since the introduction of risk-based capital (RBC) regimes, bringing investment risks more directly into insurers’ capital positions.

Greater derivatives use also raises practical questions. How should insurers control bilateral counterparty exposure? How should insurers monitor and manage their liquidity needs and resources? How can they show auditors that a position provides an intended exposure rather than speculation? And what governance, systems and expertise are required? These questions can determine whether a derivative strategy works as intended.

From individual trades to balance-sheet management

Europe’s Solvency II framework offers useful lessons for insurers in Asia. For instance, Hong Kong, like the local RBC regime, follows a three-pillar structure and applies capital shocks to interest rates, equities, credit and currencies, although the precise calibrations differ.

More than 500 European insurers now use derivatives, with close to €3 trillion ($3.4 trillion) in total notional exposure.¹ Usage has grown significantly since Solvency II took effect in 2016, as market movements feed directly into solvency ratios and increase the need to manage assets and liabilities more precisely.

Interest-rate risk is often the first priority. A duration or convexity mismatch can damage an insurer’s capital position when rates or yield curves move sharply. Swaps, bond forwards and options allow that exposure to be adjusted without restructuring a large physical bond portfolio – which is particularly valuable when existing holdings carry unrealised losses.

Separating yield decisions from duration needs

One of the most useful roles for derivatives is to separate credit selection from liability matching.

Without derivatives, an insurer seeking more duration may be pushed towards long-dated, less-liquid bonds, which do not necessarily offer the most optimal return for their capital cost.

Managing credit and duration separately gives the investment team more freedom. It can select assets offering attractive spreads and return on capital, use swaps or bond forwards to add duration, and hedge overseas exposures into the currency of its liabilities while maintaining the required amount of domestic duration.

This can be useful for floating-rate assets such as collateralised loan obligations, which may offer attractive income but little duration. The insurer can add the required duration separately rather than rejecting the asset on ALM grounds.

It may also hedge specific points on the yield curve, since liabilities respond differently to short-, medium- and long-term rate movements.

Finding value in FX hedges

Optimised currency risk hedging techniques can also allow insurers to diversify their credit portfolio away from their domestic market while minimising hedging costs, catching relative value opportunities and factoring in their ALM need.

Rather than implementing a systematic and basic hedging approach through, for example, short-dated FX forwards, insurers can exploit a broader set of hedging techniques to reduce hedging costs or even generate a pick-up depending on market conditions while building the domestic duration that they need.

For instance, when the currency basis is cheaper on the short end of the curve, one can implement a “decomposed cross-currency hedge” to hedge a portfolio of foreign fixed income investments.

The approach consists in executing payer interest rate swaps to get rid of the foreign duration, receiver interest swaps to build the required domestic duration and short-dated FX forwards to hedge the currency risk at a lower currency basis cost. When the currency basis becomes less expensive on the longer end of the curve, better conditions can be locked in by replacing the short-dated FX forwards by longer term basis swaps. This is a configuration we have observed and exploited in the HKD/USD market back in 2020.

Managing equity exposure without surrendering potential returns

Equities pose a different challenge. Their long-term return potential is attractive, but their capital treatment under specific RBC rules can be demanding (as it is under Solvency II).

An equity hedging programme using options can reshape this trade-off. BNP Paribas Asset Management’s analysis suggests this approach could cut the capital requirement by as much as 40%, while preserving up to 80% of the equity return.

The principle can also apply at the product level. For an indexed universal life policy, for example, the combination of bonds and options can help an insurer support a guarantee while giving policyholders some participation in equity-market gains.

From investment idea to controlled implementation

None of this removes the need for strong controls. Derivatives bring counterparty and liquidity risks, while mark-to-market movements may create accounting volatility. Heavy bilateral use therefore requires counterparty limits, collateral arrangements and stress testing.

Clear documentation is equally important. Insurers must be able to explain to auditors what exposure a derivative creates or removes, why it is consistent with the investment mandate and how it will be monitored. That information becomes important when auditors or internal control teams question whether a position is managing risk or adding it.

The biggest barrier to wider use may be the operating model rather than the instruments themselves. Some insurers will build the systems and expertise internally; others may use a fund or investment wrapper and place more of the implementation burden with an asset manager, even though accountability remains with the insurer.

Seen in this context, derivatives need to play a key role in how portfolios are built. They allow an insurer to make choices about its credit, interest-rate, currency and equity exposures – and about the capital it is prepared to commit to them. For insurers working under RBC, that balance-sheet control is becoming increasingly difficult to overlook.

Read more about BNP Paribas Asset Management's insurance solutions
 

Arnaud LeBreton

Stéphane Marot 

_{Sources -
1 - Source: EIOPA’s Financial Stability Report, December 2022} 

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