Derivative Exposure of 105 Trillion Won, Insurance Companies Face Growing Currency Hedge Risks Amid Financial Instability

Source: Korea Deposit Insurance Corporation

[Asia Economy Reporter Changhwan Lee] Recently, as volatility in the financial markets has increased, concerns have been raised about the potential deterioration in the profitability of insurance companies. With greater volatility in exchange rates and interest rates, the cost of currency hedging for foreign currency assets held by insurers is rising, which could negatively impact overall profitability, warranting caution.

According to the "Financial Risk Review, Life Insurance Companies' Currency Hedge Structure and Risk Factors" report by the Korea Deposit Insurance Corporation on the 24th, uncertainties in financial markets related to interest rates and exchange rates have increased due to factors such as U.S. monetary tightening and Russia's invasion of Ukraine. This may lead to increased currency hedging costs for life insurance companies.

As of the end of last year, domestic life insurers' foreign currency assets amounted to 129 trillion KRW, an increase of over 100 trillion KRW compared to the end of 2013. The 129 trillion KRW represents about 13.3% of the total assets under management by life insurers. Of the 129 trillion KRW, foreign currency securities account for 127.5 trillion KRW, making up the majority. The remainder consists of loan receivables, deposits, and others.

Foreign currency securities are primarily bonds, followed by beneficiary certificates, other securities, and stocks. By currency, U.S. dollars are the largest at 92 trillion KRW, followed by euros at 16 trillion KRW, and Australian dollars at 6 trillion KRW.

Life insurers hedge currency risk to stabilize the cash flow when converting foreign currency assets into Korean won. As of the end of last year, about 81% of foreign currency assets in the life insurance sector were hedged. Approximately 105 trillion KRW is exposed to currency hedging risk.

Currency hedging fixes the exchange rate to prevent losses from sudden fluctuations in exchange rates. However, if the exchange rate exceeds the agreed threshold, significant losses may occur.

Source: Korea Deposit Insurance Corporation

Most of the currency hedging by life insurers is conducted through derivatives such as currency swaps (CRS) and foreign exchange swaps (FX Swap).

Among these, currency swap contracts accounted for 62% as of the end of last year. A currency swap is a contract where the principal amounts in different currencies are exchanged at the start, and at maturity, the principal is re-exchanged at the agreed exchange rate.

Insurers enter into currency swaps in a form where they receive foreign currency at the time of contract to finance the acquisition of foreign currency assets and for currency hedging. Typically, if the interest rate on dollar-denominated bonds rises, the cost of currency swaps increases.

Foreign exchange swaps account for 22%, which are contracts to exchange different currencies for a set period under agreed conditions. The cost of hedging with foreign exchange swaps is determined by the swap points, which are the difference between the forward exchange rate and the spot exchange rate. The greater the exchange rate volatility, the higher the cost.

The report argued that as currency hedging conditions worsen, insurers should establish flexible strategies such as reducing the proportion of currency hedging.

Cha Hoseong, a senior researcher at the Korea Deposit Insurance Corporation who authored the report, explained, "Currency hedging is a means to reduce exchange rate risk, but its cost has variable characteristics depending on changes in market conditions, so in some cases, the cost of hedging can offset the risk reduction effect."

He added, "Despite the considerable costs incurred by the life insurance sector due to currency hedging, discussions on optimal currency hedging strategies remain somewhat insufficient. It is necessary to develop optimal currency hedging strategies considering the trade-off between cost and benefit, as well as the portfolio of assets and liabilities held."

This content was produced with the assistance of AI translation services.