Hedging costs could be a thorn in Korean insurers’ overseas investments

With firms ramping up overseas investment due to local stagnation, report warns of the risks they may face

Hedging costs could be a thorn in Korean insurers’ overseas investments

Insurance News

By Gabriel Olano

As Korean insurers struggle with a stagnant domestic market, a report by Fitch has found that firms will continue ramping up overseas investments, especially bonds, but hedging costs may place pressure on profitability.

The report said that Korean insurers’ overseas investments seek to match the asset-liability duration gap, as well as seek higher investment yields. The 10-year Korean government bond yield has been lower than the US 10-year over the last few years. Furthermore, the competition for long-term domestic investment assets has intensified.

There is also a need to minimise the duration gap by lengthening asset duration, as liability duration has been increasing in line with the concentration of sales for long-term products. However, the domestic supply of longer-maturity bonds is limited, the report said.

According to Fitch, this increased overseas investment can reduce asset risk and interest-rate risk, as the credit quality of overseas bonds remains high. Over 90% are in international rating categories of ‘A’ and above, based on an aggregated Fitch-rated insurers’ investment portfolio. Insurers often use overseas bonds for duration match to reduce interest-rate risk.

However, this could result in potential currency mismatch risk between assets and liabilities. While most insurers seek to maintain a 100% hedge ratio to avoid exposure to such risk, they may still be exposed to residual rollover risk, especially in short tenors, according to the report. Additionally, the companies need to bear hedging costs – currently about 100bp – which could exert pressure on insurers’ profitability.

The international ratings agency expects Korean insurers to raise their exposure to foreign investment – especially long-term bonds – to manage interest-rate risk and in preparation for the implementation of IFRS17 and K-ICS, beginning 2022.

One factor that may reduce overseas investment, however, is the introduction of ‘co-insurance’ in April. This will allow primary insurers to transfer the entire risk of their insurance products to reinsurers, which will reduce the interest-rate risk, therefore incurring less burden on asset-liability duration mismatch.

While Korean insurers may also consider overseas alternative investments, these also come with some risks that may expose their portfolio to market downturns or external shocks.

“We think that the risks of overseas alternative investments are insignificant at the moment, because the proportion of the overall investment portfolio is still quite small,” Fitch said in the report. “However, the absolute amount has been increasing in line with the demands from the insurers to pick up investment yield. This could therefore be one of the assets that should be looked at carefully in the future.”

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