Taiwan's Cathay Life is finding US bonds increasingly attractive because yields are rising and hedging costs are falling and sees the asset class as important to help reduce duration mismatch risk under the upcoming domestic solvency regime.

The life insurer, which had T$6.94 trillion ($244.3 billion) of assets at the end of 2020, posted a drop in international bond exposure when it announced its results on Monday (March 22). Overseas bonds accounted for 58% of its portfolio as of December 2020, compared with 58.9% a year before.

However, US bond yields across the board, ranging from 30-year Treasury bonds to 30-year triple-B bonds, have increased by about 80 basis points year-to-date, a senior executive at Cathay Holdings said at the result announcement. “Interest rates [in the US] are rising steadily, the stable income [from the bond investments] in the next five years will go up too,” he added.

Cathay Life's asset allocation

Source: Cathay Life

Meanwhile, hedging costs have fallen by 1.8 percentage points year-to-date to 4.6% on average and are expected to drop further by 20 to 25 basis points this year. This is in stark contrast compared to last year when the Taiwanese dollar gained about 1.6%. The executive did not provide details on how Cathay Life planned to adjust its portfolio in the coming year.

While lower hedging costs will make overseas bond investments more appealing, there are other reasons for investing in US credit. For one, long-dated US bonds can help local insurers lengthen asset duration, a measurement of interest rate sensitivity expressed in years.

MINIMISING DURATION RISK

Reducing duration mismatch risk, or closing the duration gap between insurers’ assets and liabilities to better manage interest rate risk, is becoming increasingly important because the risk-based New Generation Insurance Solvency Regime will be implemented in Taiwan in 2026.

“We have been lengthening our asset duration in the past years… The future [capital] charge for interest rate risk will be much higher than it is now, so we have kept our focus on our asset-liability structure and managing interest rate risks,” the executive said.  

The executive said Cathay Life’s asset duration had lengthened to 12.2 years on average as of the end of 2020, from 10.2 years in 2016, while its liability duration was about 15 years. This means the duration gap is less than three years.

It makes sense for Cathay Life to invest more in US bonds from another regulatory perspective.

Taiwan insurers are only allowed to invest 65.25% of their investable assets overseas, but this limit does not take into account a quota on assets from foreign-currency policies. On March 9, the Financial Supervisory Commission (FSC) proposed to increase this quota from 35% of the capital reserve for non-investment-linked policies to 40%, which effectively means that insurers can invest more overseas.

Authorities have not mentioned the timeline for the rule change, but many insurers are seen starting to put in place strategies ahead of its implementation.

US bonds are of particular importance to insurers in Taiwan since their foreign-currency policies are mainly denominated in dollars. US dollar credit continues to represent the vast majority of long-end bonds with a yield pick-up versus other developed credit markets and should remain the asset class of choice for them, said Denis Resovac, head of insurance strategy for Asia Pacific at Robeco.

OVERSEAS EXPOSURE

With the potential rule changes and rising bond yields, Taiwan’s insurers are seen likely to lift their overseas exposure gradually. Thibaut Ferret, Aberdeen Standard Investments’ senior solutions director for Asia Pacific, told AsianInvestor that the proportion of overseas investment for Taiwanese insurers was so far in line with some other mature markets in Asia such as Hong Kong and Singapore, where the domestic investment markets are small and are usually subject to ultra-low interest rates.

Thibaut Ferret,
Aberdeen Standard

This overseas investment level should not be assessed on a stand-alone basis, but relative to the currency and nature of the liabilities the assets are backing, and along with the foreign exchange hedging exposure, Ferret said.

"Increasing offshore asset exposure provides more investment choices to insurance companies and might reduce the overall market risk through diversification, reduced concentration, increased liquidity and access to new asset classes," he added. "That is why some countries do not have caps or have recently increased the limits."

The concern might be on the mismatch risks these offshore investments bring to the balance sheet. Still, insurers in Taiwan and elsewhere in Asia are already managing these risks in their internal risk framework. These risks are also reflected in the existing or incoming risk-based capital regimes, making regulatory hard-limit probably less relevant from a financial risk perspective, he said.