Insurers are permitted to use derivative financial instruments, if only to a limited extent – to mitigate risks, for example (see info box). Nevertheless, the use of derivatives in the industry is steadily increasing. Most insurers use derivatives for hedging purposes, as in the case of foreign exchange risks. In addition, some insurers use derivatives with the aim of yield enhancement.

These were the findings of a large-scale survey conducted by BaFin at the end of 2020 (see info box).

Is this trend continuing? Just under a year after the survey, BaFin conducted intensive discussions with selected insurers in search of answers to this and other questions. Topics included the products used by the companies, their investment strategies and their risk management. BaFin had primarily selected those insurers that showed a high level of notional exposure in derivatives. The supervisors were interested in discussing the topic with insurers that used derivatives either solely in their direct holdings or in their fund holdings, or in both.

Trend towards derivative use continues

The results of these discussions indicate that the trend of using derivatives remains strong. There has been a steady rise in the notional volume of derivative transactions over the past few years. The vast majority of insurers are using them for hedging purposes. Interest rate swaps, for example: while they were primarily used in the past to hedge the interest rates of bond portfolios, at present they more often serve the purposes of duration management.

In addition, there has recently been a significant shift: insurers are now mainly using derivatives for exchange rate hedging – predominantly in the form of forward exchange transactions. One of the reasons for this is the increasingly international diversification of the capital invested; another is the persistently low interest rate environment in the euro area.

The discussions showed that insurers are investing more heavily in bonds issued in foreign currency. Special attention is being paid to bonds issued in US dollars, British pounds and Danish kroner. This allows insurers to benefit from the exchange rate-driven interest rate differential compared to securities issued in euros – even if the hedging costs are taken into account. Any foreign exchange risk the insurers assume in this process is passed along, predominantly by means of derivatives.

In addition, though to a lesser extent, the insurers use derivatives as preliminary steps towards future security purchases. Their focus in this respect is on forward purchases. Of minor significance, on the other hand, are the derivatives used for efficient portfolio management.

Derivatives as a means of yield enhancement

Another trend that had already become evident in the BaFin survey was that in times of low interest rates insurers use derivative instruments more and more often to increase their yields. It is particularly noteworthy that the insurance companies doing so make use of fund constructs such as master funds which themselves involve a target fund designed to implement derivative strategies. This also includes strategies intended to enable a higher yield by means of earned option premiums. BaFin is closely tracking this development, demanding that the insurers deal critically with the additional risks in line with the prudent person principle and their risk-bearing capacity.

BaFin expects risk assessment and transparent reporting

BaFin expects those insurers making increased use of derivatives to have a critical and comprehensive look at the related risks. To be able to do so, they must have an appropriate risk management system in place. In addition, BaFin expects the companies to report transparently and comprehensively on their use of derivative financial instruments.

The issue of derivative instruments will be a priority area in BaFin’s next survey regarding the investment behaviour of insurance companies. This survey is scheduled to be conducted this year.