Tailored currency hedging allows the investor to manage these risks and other key sensitivities. It is a multifaceted activity that requires significant expertise with financial instruments and understanding of how they interact with the complexities inherent in insurance balance sheets.
This article focuses on European insurers that use fixed income assets to match their liabilities.
Why currency hedging is so important for insurers
Most European insurers are already active in government and corporate bond markets, but can benefit from a more international view. For example, US treasuries provide higher returns after hedging than German and Dutch (also AAA-rated) sovereign bonds at longer maturities. The US corporate bond market is the largest and most liquid in the world, but still provides European investors with a premium to local markets after hedging. Many US companies only issue debt within their home market which allows European investors to diversify their investable issuer base. Finally, emerging market debt (EMD) is an established but growing asset class with attractive returns that is almost entirely non-euro denominated and therefore needs a hedging solution.
For an insurer with euro-denominated liabilities, investing in USD assets not only introduces currency risk but also foreign (USD) interest rate risk. When using a matching approach, this also creates an implicit short interest rate risk versus the liabilities. When hedging liability driven investing (LDI) portfolios at NN IP, we typically consider FX an unrewarding risk, meaning that the investor seeks exposure to the asset class rather than the currency. The objective of the strategy thus becomes hedging all of the currency risk, and also potentially the other associated unrewarding risks like foreign interest rate risk.
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