Insurance Europe briefing note: Currency risk

22 March 2013

This paper focuses on how currency risk is of particular relevance to insurers and reinsurers, and why the current Solvency II approach is of great concern. It outlines the industry's proposal to alleviate these concerns.

Currency risk arises when obligations an entity has promised to fulfil (liabilities) are in a different currency from the assets it holds to cover those liabilities. This exposes the entity to fluctuations in exchange rates. In particular, it poses a threat if the value of the currency in which liabilities are priced appreciates relative to the currency of the assets.

Currency risk applies to insurers and reinsurers as well as other businesses. The Solvency II Framework Directive requires currency risk to be assessed over the coming 12 months to calculate an insurer’s solvency capital requirement (SCR).

An essential starting point is to ensure that any assets held to cover anticipated costs are in the same currency as they are expected to occur. This is both logical and consistent with sound risk management and relates to the principle of “matching”. By currency-matching assets and expected liabilities, any movements in the dollar/euro exchange rate would impact the assets and the expected cost estimates equally and therefore have no “bottom line” impact on the finances of the firm. However, the opposite is also true: unmatched currency positions lead to increased currency risk.

The currency risk sub-module is part of the Solvency II standard formula’s market risk module. The Solvency II Framework Directive describes currency risk as: ”The sensitivity of the values of assets, liabilities and financial instruments to changes in the level or in the volatility of currency exchange rates”.

Article 172 of the draft Level 2 measures sets out the method of calculating the currency risk submodule capital charge under the standard formula. Essentially it requires an insurer to apply 25% to its “net asset value” (assets less booked liabilities) for a foreign currency (any currency other than that used to prepare its financial statements). This was also the approach in the fifth quantitative impact assessment (QIS 5).

The current approach to currency risk is flawed because it penalises insurers for reducing their exposure to currency risk while it rewards them when they increase it. As such, the current approach results in the following shortcomings:

• It does not reflect real currency risks faced by insurers. It does not result in any capital charge if a firm holds all of its excess assets in the local currency, even in cases where some of its liabilities are labelled in a foreign currency.
• It incentivises poor risk management. It encourages undertakings not to hold surplus assets in foreign currencies and therefore not to maintain prudent buffers against foreign currency risks, as both logic and sound risk management dictate. The European Insurance and Occupational Pensions Authority’s QIS 5 report noted that this effect was “counterintuitive”.
• It does not satisfy the Directive requirements as it only assesses the potential impact of currency fluctuation on the opening positions of assets and liabilities but does not take into account the uncertainty of how assets and liabilities could vary.

Insurance Europe’s proposal introduces the concept of currency risk exposure (CRE). This measures currency mismatching by comparing the proportions of assets and liabilities held in foreign currencies.

The CRE for foreign currency C is:

Insurer’s total assets x (percentage of assets in currency C – percentage of liabilities in currency C)

The CRE is then subject to a 25 per cent shock. The results for all an insurer’s foreign currencies are added up to make its total currency risk capital requirement.

Full briefing note

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