Interest rate hedging alternatives for the insurance industry | Insights | Bloomberg Professional Services (2024)

Derivatives are key risk management tools that enable financial and non-financial institutions to diversify their risk portfolio and reduce earnings volatility. The insurance industry specifically uses derivatives to hedge a multitude of risks, including actuarial, market, liquidity, credit and other operational risks.

A life insurance company that offers interest rate guarantees on its products relies on derivatives to hedge against low interest rate environments — a scenario familiar for the last decade. Insurers use different instruments for hedging interest rate risk, such as bond forwards, forward starting swaps or receiver swaptions. Each of these instruments, when deployed, generates a different hedging outcome.

Alternative types of hedging instruments

In emerging markets, insurers use interest rate forward contracts, an agreement to buy/sell an underlying on a future date, to hedge risk. If the underlying is a debt instrument, for example, a 6% coupon 2023 government bond, then that instrument can deliver a fixed yield to the insurance company. Ultimately, this allows insurers to hedge interest rate risk on the premium payments expected in the future. Typically, an insurance company would lock in the price of the underlying at inception and, therefore, be aware of the effective yield that could be achieved by using such derivative. Such strategy is a mechanism to mitigate the volatility associated with changes in yields.

Another instrument to hedge risk is forward starting swaps, where an insurer would enter into receiving a fixed interest rate swap. Swaps are used extensively to manage interest rate risk; therefore, pricing against a LIBOR floating has much more liquidity when compared with an illiquid bond forward. The two parties (buyer and seller) may eventually settle at the time when an actual investment is made. The net settlement payment would be equal to the present value of the difference between the original swap rate and the swap rate at the time. This implies that the two strategies presented above will typically yield similar results when adopted.

The third type of instrument is to buy a receiver swaption. This swaption gives the insurer the ability to enter into a swap on a future date at the expense of paying an upfront premium. The advantage is that if the markets move in favor of the insurer and yields in the market are higher than what the firm wishes to lock in, then the insurer may simply let the option expire. As IFRS 9 provides preferential treatment for time value of options, this strategy could be the most effective to hedge risk if Vol remains low. Even though proving hedge effectiveness as required under IFRS 9 is easier for a forward hedge, other instruments, because of their liquidity and their participatory nature, can be more effective at hedging risk. This means IFRS 9 allows time value of options to be excluded from the effectiveness assessment and to amortize them over the life of hedge, thus reducing the P/L volatility resulting from time value changes.

To effectively adopt risk management under the new accounting and reporting standards, insurers must revisit hedging policies and evaluate internal systems to enable them to best manage risk and be in compliance when reporting such risk. Each instrument used for hedging interest rate risk will have different implications. However, by using automated solutions that provide an overview of all potential risks that can affect businesses, regardless of industry type, companies are closer to achieving the efficiency and transparency necessary to comply with new and evolving market demands. Bloomberg’s Multi-Asset Risk System (MARS) platform enables financial professionals to visualize their risk and comply with hedging standards such as IFRS 9 and IFRS 13, thus enhancing financial risk management throughout the enterprise.