Solving the duration mismatch to address Asian insurers’ interest-rate risk

Max Davies, CFA, CAIA, Insurance Strategist
Francisco Sebastian, FIA, ALM & Regulatory Capital Strategist
2023-12-31
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One of the few constants in Asia’s diverse and dynamic life insurance landscape is the search for long-dated investments that hedge liabilities. By nature, the industry generates liabilities that tend to have a longer duration than the assets on life insurers’ balance sheets. The resulting duration gap exposes life insurers to changes in interest rates that will soon incur higher capital charges due to the new risk-based capital (RBC) regimes being introduced across Asia. In addition, insurers could face increased volatility in their balance sheets as the new accounting standards in IFRS 17 (and IFRS 9) come into effect on 1 January 2023.

Against this backdrop, there is an urgent need for improved asset/liability management (ALM) practices among the region’s insurers. Here, we outline potential approaches for insurers to reduce the mismatch between their assets and liabilities and to better manage their interest-rate exposure.

Why is there a duration mismatch?

Domestic fixed income assets are the most obvious ALM tool because of the predictable nature of the cash flows and their likely alignment with the principal currency of the liability exposures. However, the lack of depth and maturity in many Asian markets (Figure 1) means that the supply of domestic fixed income assets often fails to meet the specific demands from domestic life insurance companies. Insurers must also contend with the limited availability of long-dated bonds in local currency, which is particularly true of the corporate sector.

Figure 1
Market value outstanding in local-currency bond markets

Diversifying to address the duration mismatch

A number of diversification approaches across asset classes and regions could offer potentially compelling solutions to the duration mismatch problem.

  • Go global with corporate bond exposure
    Given the domestic supply constraints, exposure to non-domestic corporate bond markets is a necessity for many insurers in Asia. Non-domestic markets can offer duration extension, yield opportunities and potential diversification benefits, both from the domestic credit cycle and through broader sector coverage. Historically, the US credit market has been the most fertile hunting ground for non-domestic opportunities in the corporate bond market, and insurers in some of the most mature Asian markets are now meaningful owners of US-dollar credit.
  • Consider derivatives for duration
    Derivatives play a key role in keeping underlying asset portfolios intact while helping to mitigate interest-rate risk. As a result, they are becoming an increasingly important component of ALM among insurers in Asia, particularly given the constraints on the availability of suitable assets in the domestic market. Specifically, we see the growing use of interest-rate swaps and bond forwards to gain duration and reduce the balance-sheet volatility arising from interest-rate risk. This approach enables capital to be deployed towards credit, equity or other risks that may offer a more compelling reward profile.
  • Consider increasing exposure to alternatives
    Alternatives is a broad and rapidly expanding asset class, which has attracted significant investment from global insurers given the prolonged low-yield environment that we have recently experienced. While yields in public markets are now rising, we think alternatives should remain an important part of the asset allocation toolkit for insurers, because they offer structural benefits beyond additional yield. These can include diversification, downside protection, inflation protection and potential for ESG integration, as well as duration in some cases.
  • Reassess exposure to long-duration equities
    Although equities are often disregarded when it comes to designing an ALM strategy, we think that focusing on equity sectors that correlate favourably with liabilities could help insurers achieve their return and risk-management goals. For large periods of history, equity prices have exhibited a positive correlation with interest rates and, therefore, a negative correlation with insurance liabilities. However, based on our analysis, equities from specific growth sectors show a near-zero, or even slightly positive, correlation with insurance liabilities. By region, emerging markets equities have a risk profile that is more favourable than that of developed market equities for insurers whose liabilities are more sensitive to interest-rate moves.

Towards a more diversified approach

Diversifying across a varied mix of investment options is becoming increasingly important for Asia’s life insurers as they confront the new accounting and capital regimes across the region as well as an increasingly uncertain market backdrop. Implemented thoughtfully, with the attendant currency hedging and collateral management, the diversification approaches outlined above may go some way to addressing the challenges.

Read more in our latest paper, A practical guide to addressing Asian insurers' interest-rate risk.

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