Japanese lifers boost FX hedging as new capital rules loom

Banks expect insurers to pile on long-dated JGBs and USD/JPY cross-currency swaps

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Japanese life insurers have increased adoption of cross-currency swaps and longer-dated Japanese government bonds (JGBs) in preparation for a new capital regime. The insurers are seeking to reduce their market risk in an attempt to attract lower capital requirements before the new rules come into force in 2025. 

“We estimate that Japanese life insurers increased the USD/JPY hedge ratio by over 10% in the last two years,” says Yusuke Ochi, executive director in rates structuring and strategies at Goldman Sachs. He adds the trend is set to continue as Japanese life insurers look for solutions to reduce interest rate and foreign exchange risk.

Market risk accounted for 74% of total capital requirements for lifers in 2016, figures from Japan’s Financial Services Agency (FSA) show. Requirements linked to currencies and interest rates made up 29% and 38% of total market risk, respectively. 

“Since market risk consumes the largest amount of capital, reducing this component would be the simplest way to improve the economic solvency ratio,” Ochi says.

Japan has been working on adopting a new solvency regime for the supervision of insurers for more than a decade. In 2019, the FSA created a study group to address the issue and develop economic value-based rules. Last year, the group published a report recommending the implementation of the new regime in 2025.

Under the current requirements, most Japanese lifers have a solvency margin ratio in excess of 800%, well above the 200% minimum, Ochi says. However, under the new regulation, their average ratio would fall to 178%.

The use of the economic solvency ratio is expected to be a better measure of Japanese insurers’ capital strength, as it will reflect the characteristics of their liabilities. According to a Fitch Ratings report from August 2020, the new ratio is likely to have a greater impact on life insurers given their longer liability duration – something not taken into account under the current regime. 

“Insurance liability is currently measured by the historical locked-in rate when the insurer underwrites the contract. This accounting-based measure overstates shareholders’ equity and statutory solvency margins, as it does not reflect declining interest rates and the duration mismatch between assets and liabilities,” the report stated. 

While the new regulation won’t be implemented until 2025, banks say life insurers have already started piling on US dollar/yen cross-currency swaps, which are used to hedge the bulk of the FX risk from their overseas investments. Insurers have also increased holdings of long-dated JGBs in order to fill the duration gap between their assets and liabilities – a trend that is set to continue, banks say. 

“The investment plans announced for the second half of financial year 2020 implies that insurers will increase investments in yen-denominated fixed income products and decrease holdings of foreign bonds, both hedged and unhedged,” says Ochi. 

Yusuke Ikawa, G10 rates strategist at BNP Paribas Securities Japan, adds: “Lifers are trying to reduce market risk by buying 10-year and longer JGBs as well as receiving swaps or buying receiver swaptions.”

Ikawa estimates that the demand to fill the duration gap is likely to hit ¥45 trillion ($432 billion) in the form of 30-year JGBs. Lifers may also need to buy 20-year or longer JGBs annually, worth roughly ¥10 trillion–11 trillion. 

The last time life insurers went on a JGB buying spree and sought to increase their FX hedging ratios, yields of long-dated bonds collapsed and hedging costs rose – something banks warn might happen again. 

“If many life insurers perform hedging transactions at the same time, there would be an impact on the market in that it would increase the hedging cost for these companies,” says Ochi. “That happened in June to July 2016 in the JGB market, for example. Many Japanese life insurance companies bought JGBs to hedge their interest rate risk, and as a result yields of long-end JGBs hit their lowest level.” 

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