Insurers have faced a volatile and uncertain landscape throughout 2022. Amid rising inflation, supply chain disruption and a rapid increase in the demand for goods, insurance firms have had to adjust their operational practices to navigate several bottom-line threats.
Among the growing number of challenges facing insurers is the important – yet often overlooked – consideration of foreign exchange (FX) risk management.
Insurance companies typically transact in FX not because they want to, but because they have to, given their global coverage and the subsequent requirement to pay out claims in different currencies.
Despite this, insurers are in fact responsible for a significant amount of FX trading. According to the 2019 BIS Triennial Bank Survey, “other” financial institutions such as insurance companies make up US$3.6tn in trading volumes, representing 55% of global turnover.
Therefore, against the backdrop of a variety of different pressure points and risk factors, we feel it is crucial that insurance companies implement stringent FX risk management strategies to protect their bottom lines during these turbulent times.
What is Foreign Exchange Risk?
Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies.
- Foreign exchange risk refers to the risk that a business’ financial performance or financial position will be affected by changes in the exchange rates between currencies.
- The three types of foreign exchange risk include transaction risk, economic risk, and translation risk.
- Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets.
Understanding Foreign Exchange Risk
The risk occurs when a company engages in financial transactions or maintains financial statements in a currency other than where it is headquartered. For example, a company based in Canada that does business in China – i.e., receives financial transactions in Chinese yuan – reports its financial statements in Canadian dollars, is exposed to foreign exchange risk (see M&A Transactions in the Global Reinsurance Sector will be Limited into 2023).
The financial transactions, which are received in Chinese yuan, must be converted to Canadian dollars to be reported on the company’s financial statements.
Foreign exchange risk can be caused by appreciation/depreciation of the base currency, appreciation/depreciation of the foreign currency, or a combination of the two. It is a major risk to consider for exporters/importers and businesses that trade in international markets.
FX risk a growing priority for insurers
Having thankfully left the pandemic behind, the past year has thrown up a host of new challenges for the insurance market, with the industry facing headwinds across a range of different fronts.
- Inflation and recessionary risks – inflation in the UK has persistently remained at near 40-year high levels, while soaring prices in the US also show little sign of easing. The cost of insurance claims and premiums have risen in line with inflation, meaning claims inflation and increased operating costs are now a real issue for underwriters (see Insurance Claims Management).
- Supply chain disruption – manufacturers continue to struggle to meet post-pandemic demand, with major trade hubs such as US ports being clogged up by bottlenecks due to a lack of staffing and equipment (see Business Interruption Insurance). As a result, interruption periods have become longer due to delays and backlogs, putting business interruption indemnity periods and sums insured under mounting pressure.
- Catastrophe pay outs – natural disasters caused an estimated global insured losses of US$105bn in 2021, the fourth highest since 1970. And if the summer of 2022 has taught us anything, it is that global warming and subsequent extreme weather are here to stay. As this trend continues, catastrophe pay outs are also set to carry on rising.
Furthermore, when an insurance company receives new premiums that it wishes to invest in foreign assets, it needs to enter into a foreign exchange swap if it wishes to avoid the exchange rate risk this investment will entail.
This, combined with the aforementioned factors, is heightening the exposure of insurance firms to FX risk.
Adopting a strategic approach to FX risk management
With uncertainty and inflation set to persist throughout the year ahead, we believe insurance companies must begin implementing a robust risk-management strategy to minimise their exposure to foreign currency movements.
Fortunately, there are a number of steps that insurers can take to achieve this.
- The use of Transaction Cost Analysis (TCA) – TCA was specifically created to highlight hidden costs and enables insurers to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.
- Compare the market – having the ability to put trades up for competition is central to ensuring access to the best price, which is key to effective risk management. However, many insurance firms are hampered by their inability to access Tier 1 FX liquidity, meaning they often rely on a single bank or broker to meet their hedging requirements. A new generation of fintechs is tackling this problem, enabling insurers to access rates from multiple banks whilst reducing the operational burden associated with this kind of market access.
- Outsourcing – there is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities, but when using the right partner can improve transparency and execution quality. Outsourcing can enable insurance firms to dedicate more time to core business matters, which is all the more important amidst inflationary and volatility pressures.
- Strong governance – merger and acquisition activity in the global insurance industry has increased in recent months, recently reaching the highest growth rate for 10 years in the first half of 2022. It is therefore difficult to increase transparency and meet industry best practices due to each business having different partnerships and processes. To strengthen governance, insurance firms should look to FX solutions which help improve the cost, quality and transparency of their FX execution.
The insurance industry has gone through a period of significant change over the past 12 months, and with currency movements set to remain volatile, we believe insurers must begin treating FX risk as a core business priority (see How Does AI Technology Impact on Insurance Industry?).
This means moving away from the traditional single bank-based approach to FX, and instead harnessing technology-driven solutions that offer greater transparency, governance and efficiency. Doing so will help enable insurers to adapt to this uncertain landscape as well as the future challenges that lie ahead.
Types of Foreign Exchange Risk
The three types of foreign exchange risk include:
1. Transaction risk
Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.
For example, a Canadian company with operations in China is looking to transfer CNY600 in earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would instead of CAD86 (CNY600/7).
2. Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.
For example, a Canadian furniture company that sells locally will face economic risk from furniture importers, especially if the Canadian currency unexpectedly strengthens.
3. Translation risk
Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.
For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance – which is in Chinese yuan – is translated into Canadian dollar for reporting purposes.
AUTHOR: Eric Huttman – CEO of MillTechFX