In an uncertain market environment, insurance firms should be taking advantage of derivative strategies and tools to manage risks and protect their portfolios from volatility.

Yet many insurers lack the expertise to handle such strategies, and there is a need to improve understanding about derivatives.

That was the broad view of investment specialists from some of the region’s insurers who attended AsianInvestor’s inaugural Insurance Investment Forum in Singapore last week.

“The use of derivatives has a lot of room to grow in Singapore,” Liu Chun-yen, chief investment officer for AIA Singapore, told delegates at the event on March 14.

Liu Chun-yen, AIA

She said the insurer currently uses derivatives to manage risks as well as to manage its overall portfolio more efficiently.

Pierre-Emmanuel Brard, chief investment officer for Axa Insurance in Singapore, agreed with that viewpoint, noting that insurers should be using derivatives to tackle certain kinds of risk.

“We use them [derivatives] quite a lot, mostly to manage our FX exposure,” he said. “[There are] definitely lots of things that can be done through derivatives to get more pick-up [in returns] or to protect your portfolio to be better positioned against more volatility,” he added.

"I see derivatives … as a tool that insurance companies really need to use, especially in Singapore, where we have the capability to invest offshore," Brard said.

Yet, as AIA's Liu pointed out, most insurers are not savvy about how to use such tools.

A derivative is a financial security with a value that is reliant upon, or derived from, an underlying asset, which can typically be stocks, bonds, commodities, currencies, interest rates and market indexes.

The most commonly used derivatives are swaps, options and futures. They are mainly used for hedging, transferring risk and exploiting arbitrage opportunities.

According to Monetary Authority of Singapore (MAS) regulations, insurance companies operating in the lion city are permitted to use derivatives only for hedging or improving portfolio efficiency.

RISK REDUCTION

Insurers that do use derivatives in Singapore tend to use them for hedging currency and credit risks, noted Alan Yip, head of insurance solutions for Asia Pacific with JP Morgan Asset Management.

“For instance, they swap US dollar bonds into Singapore dollars to back their Singapore-dollar denominated liabilities,” he told AsianInvestor. Relative to other Asian countries, the regulations in Singapore are relatively derivatives ‘friendly’, he added.

Nevertheless, it is important to keep the dialogue going between regulators and insurers on the use of such financial instruments, said Don Guo, chief investment officer for Asia Capital Reinsurance Group, at the AsianInvestor event.

Pierre-Emmanuel Brard, Axa

In particular, as accounting and capital regimes evolve, it is important that regulators and insurers continue to have a clear understanding of the role derivatives can play towards creating efficient portfolios.

“It is very important we keep educating our regulators as well...because derivatives [are] really a tool that needs to be used to drive the way … to being more capital efficient [and] bring in more yield,” added Axa’s Brard.

Other experts noted that insurers in other parts of the world are using derivatives in more sophisticated ways, and as the market in Asia evolves, insurers here could follow suit.

“UK and European insurers use swaptions to manage some of their exposure to very low levels of yields without changing their exposure to rising yields…I think these derivative assets can be very helpful,” said Iain Forrester, head of insurance investment strategy for Aviva Investors.

A swaption is an option on an interest rate swap. It grants the owner the right, but not the obligation, to enter into an underlying swap.

With the market for derivatives in the region continuing to evolve, insurers will, in time, be offered more choices to manage their “tail risks”, Forrester told AsianInvestor.

Broadly speaking, a tail risk is an event or an outcome that has a very small probability of happening. But it can lead to either massive gains or humongous losses.

Of course, as with all strategies, using derivatives comes with its own set of risks.

“One of the challenges of using derivatives is related to the potential profit and loss (P&L) fluctuations caused by any changes in mark-to-market value of derivatives,” noted JPMAM’s Yip. “In certain cases, insurance companies can apply hedging accounting [guidelines] to control these P&L fluctuations,” he added.

In its guidelines, MAS also makes it clear that insurers can invest in derivatives only if they are capable of assessing the nature, scale and complexity of risks associated with such investments.