Revisions proposed to foreign-exchange volatility reserve rules by Taiwan's insurance regulator, the Financial Supervisory Commission (FSC), would incentivise insurers to lower their hedged ratios (i.e., the share of their foreign currency portfolios hedged with traditional instruments such as nondeliverable forwards and cross-currency swaps) against potential Taiwanese dollar appreciation, according to a commentary by Moody's Investors Service.
On 29 January, the FSC proposed the changes that Moody's says would be credit negative for Taiwanese insurers.
Under the proposed rules, insurers can use the reserve to offset up to 60% of their foreign exchange gains/losses, versus 50% currently, when the market hedging cost of currency swaps is higher than 2% of the notional value. Essentially, the new rules will reclassify a larger proportion of the earnings effect from foreign-exchange rate movements outside insurers’ income statements. This is done by allowing insurers to reserve part of their retained profits to absorb potential foreign-exchange losses.
Mr Kelvin Kwok, analyst, and Ms Sally Yim, associate managing director, both of the Financial Institutions Group at Moody's, say that the increased flexibility to shield accounting earnings from foreign-exchange volatility will reduce insurers’ incentive to hedge their overseas investments amid rising hedging costs. This will result in higher earnings sensitivity to foreign-exchange rate movements. Taiwanese insurers have accumulated foreign-exchange risks from rising overseas investments, a substantial portion of which are not backed by foreign-currency insurance policies. Overseas investments comprised 67.9% of Taiwan insurers’ investments at the end of September 2018, up significantly from 57.6% at the end of 2015. Lower hedged ratios will add to insurers’ already-high foreign-exchange risks.
The Moody's commentators say that the foreign-exchange volatility reserve is not a good substitute for hedging arrangements even from an accounting perspective because the reserve could be depleted quickly in the event of material foreign-exchange rate shifts. The life industry had significant foreign-exchange losses when the Taiwanese dollar appreciated nearly 10% against the US dollar in 2017. This was accompanied by a rapid depletion of the industry's reserve which forced the regulator to raise the reserve requirement.
As part of the regulator's revisions to the reserve rules, monthly reserve provisioning rates will rise to 0.06% of insurers’ unhedged foreign-currency positions from 0.05%. However, this will mitigate, but not eliminate, the reserve depletion risks. This is because the resultant monthly addition to the reserve, which based on our estimate is around NT$0.5bn ($16.2m) for the whole industry (assuming that 30% of overseas investments are unhedged or not backed by foreign-currency insurance policies) will be small relative to the insurers’ overseas investments, which were NT$16.1trn at the end of September 2018.
Nonetheless, lower hedged ratios will reduce insurers’ hedging costs and boost their short-term profitability if currency rates remain stable. Hedging costs have risen since early 2018 because of a widening in the US and Taiwan interest rate differential. In 2018, the life industry incurred a hedging cost of NT$484bn, compared with a pretax profit of NT$84.2bn. However, this cost savings could come at the expense of insurers’ profitability if and when they are caught at the wrong end of a surge in foreign-exchange volatility.