Taiwan's Financial Supervisory Commission (FSC) has announced higher requirements on insurers' foreign-exchange volatility reserves. The tightening is credit positive for Taiwanese insurers because it requires them to set higher foreign-exchange volatility reserves as a buffer against potential foreign exchange losses and will push them to increase their hedging ratios against potential appreciation of the Taiwanese dollar, says Moody's Investors Service Hong Kong.
The rule change, announced last week, will increase the monthly required provision rate to the reserve to 0.05% of insurers’ unhedged foreign-currency exposure from 0.042%. It also will raise the minimum required balance of reserves to the higher of either 20% of the previous year’s outstanding balance or 20% of the average yearend outstanding balance between 2012 and the latest year-end. Previously, the minimum required balance was 20% of the outstanding balance in the previous year. Additionally, insurers must set aside 75% (up from 60%) of their monthly foreign-exchange gains from their unhedged positions for the reserves if the outstanding balance of their reserves is lower than the minimum required balance for three consecutive months until the reserves increase to 3x the minimum required balance, up from 2x.
The requirement to set aside such reserves began in 2012 to allow insurers to adopt flexible hedging strategies and reduce their hedging costs by absorbing 50% of the accounting earnings effect resulting from foreign-exchange movements through these reserves.
Mr Frank Yuen, Assistant Vice President - Analyst, Financial Institutions Group, Moody's Investors Service Hong Kong, said in an article in the 15 January 2018 issue of "Moody’s Credit Outlook", said that the higher provision requirement will speed up the recovery of foreign-exchange volatility reserves, which have declined among major insurers as a result of the continued appreciation of the Taiwanese dollar, which strengthened by 8.02% between the end of December 2016 and the end of December 2017.
The new rules will incentivise insurers to increase their hedging ratios, which currently range between 20% and 30% among major Taiwanese life insurers, because it becomes more costly to provision for their unhedged positions. Aside from having to maintain provisions for their unhedged positions, insurers now will have to maintain higher required minimum balances on their reserves before they utilise them to absorb foreign-exchange losses. To avoid the currency movements of their unhedged positions from directly affecting their earnings, insures will curtail their unhedged positions.
Although the rule change may dampen insurers’ profitability owing to the higher provision charges, the expected improvement in earnings stability will offset the negative effect on earnings. It also provides a larger capital buffer in case the Taiwanese dollar appreciates further.
Despite the tightening, Moody's expects that Taiwanese insurers will continue to invest substantially in overseas securities to accommodate the persistent accumulation of spread-dependent products on their books and reinvestment pressure from a low, albeit rising, interest rate environment. The resultant currency risks and asset and liability challenges underpin the international credit agency's current negative outlook on the industry.