Insurance companies in Asia are increasingly considering using new types of structured products and derivatives alongside investments, to better hedge their risks and raise returns in a low-yielding environment.

The new structured products are designed to incorporate smart beta and index replication, rather than speculate on market movements.

In recent years insurance companies have typically used derivatives to manage interest rate risk at a balance sheet level or to hedge undesired foreign exchange risks when diversifying offshore. The instruments of choice have been interest rate swaps and bond forwards.

However, Markus Danninger, manager of Generali China, said the companies are looking beyond simple hedging tools and considering new fund vehicles and structured notes.

“We can control volatility using smart products and balanced funds with low fees. We can also use futures within a fund structure to hedge out certain risks,” he told AsianInvestor.

This has been going on for some time with the big global insurers, but is becoming more widespread among local Asian players too, Danninger said. 

New products

Structured products were tainted by their heavy adoption in the buildup to the global financial crisis of 2008. Lesley Lo, head of insurance and endowments for Asia Pacific at BNP Paribas Investment Partners (BPPIP), noted that structured products being used before 2008 tended to speculate on the movements of equity, currency or commodity markets.

In contrast, she said the products being offered today are “more to do with the index creation and the financial engineering behind it", and able to help investors control their risk and returns. 

“Insurance regulations do not generally allow use of derivatives for speculation, so it would be difficult for them to get regulatory approval to have a total return swap, or a more complicated structured product, to put into their balance sheet," added Lo.  

Some of the newer structured products incorporate ideas from smart beta strategies, using swaps or some sort of note (such as a credit-linked note) to identify and link to the performance of an underlying basket of investments. As with smart beta, the basket of instruments is typically chosen based upon factors such as book value or earnings quality. The factor provides the potential yield enhancement or helps to hedge risk.

Lo pointed to relatively transparent and plain vanilla structured products (containing a basket of domestic blue chip stocks), which are being created in some countries like Korea, Taiwan and the Philippines for yield enhancement.

BNPPIP has focused on offering regional insurers equity or risk asset portfolios with protection: “Things like smart floor strategies, which protect the portfolio value according to a specified net asset value floor, or having a risk target portfolio, where you control the volatility or the value-at-risk level,” said Tino Morrees, Hong Kong chief executive at BNPPIP. 

Hedging efficiency

Insurance companies in Asia are also increasingly considering derivatives for their hedging potential, ahead of the introduction of new risk-based capital rules being implemented across Asia.

Singapore looks set to be one of the first Asian countries to introduce the new rules, which emulate the Solvency II rules that came into full effect across the European Union at the beginning of this year. The coming rules could make it even more costly for insurers to diversify investments.

Today’s capital rules already place high charges on some forms of investment and restrict the use of derivatives for anything other than hedging. Insurance companies and advisers have been lobbying lawmakers to liberalise existing caps or capital costs relating to alternatives investments.

Some of the new derivative products can help mitigate risk under the capital rules. Chinese insurers, for example, are seeking new solvency-efficient investments that use derivatives in a packaged fund. These products focus on lowering volatility and duration matching without raising capital charges.

“De-risking a portfolio by using hedging or options strategies to bring down the volatility, without bringing down the returns too much; those are interesting solutions for an insurance client,” said Morrees.

Additionally, solvency regulations in Asia remain favourable to real assets, and as institutions diversify away from equities and bonds they are placing more emphasis on infrastructure debt, real estate or other private equity investments.

Insurance companies can use derivatives to help hedge these investments, but they have to be very explicit on the use of derivatives in their portfolio, Paul Sandhu, head of risk and capital management at Conning in Hong Kong, told AsianInvestor.

“Generally derivative structures used for "hedging" carry a lighter capital charge than derivative structures used for "return enhancement",” he said. In many cases, derivatives such as foreign exchange swaps can reduce the overall capital charge on investments.