Effective Currency Risk Management: Why Insurers Should Hedge

Introduction

The sheer scale of the insurance industry is evidenced by the €6.2 trillion in premiums amassed by insurers worldwide in 2023, marking an impressive 7.5% increase over 2022 — the fastest growth rate since the pre-global financial crisis era.[1] For insurers that operate across borders, there’s an inherent concern that, if overlooked, can lead to financial volatility and profit erosion: currency risk.

It’s the role of an insurer to be adept at providing financial protection and risk management to individuals and organizations for unforeseeable events. By applying this familiar approach to operations by hedging currency risk, insurers can insulate overseas revenues and investments from the unpredictable variables that affect exchange rates.

Currency Volatility 101

It’s well known that global exchange rates are in a perpetual state of flux. When the rate between two currencies fluctuates more than average in a short period, this is called currency volatility. This fluctuation is often triggered by several factors, most notably geopolitical events, economic data, and market sentiment.

If unaccounted for, currency volatility can create challenges that impact an insurer’s financial stability and profitability, including:

• Reduced premium income;
• Increased claim payments and claim liabilities;
• Inaccurate budgeting and forecasting;
• Unexpected costs; and
• Cash flow uncertainty.

 A Fit-for-Purpose Hedging Strategy: The Basics

 A hedging strategy is a formalized approach to currency risk management that involves taking proactive measures to reduce or offset the impact of market volatility on a business’s financial performance. This results from engaging in financial contracts, such as forwards, futures, and options, all designed to protect against unexpected currency volatility. The extent to which a business hedges its position is influenced by the level of risk it is exposed to, as well as its level of risk protection. By removing the inherent uncertainty associated with exchange rates, insurers can stabilize cash flows and protect profit margins.

There’s no “one-size-fits-all” approach to hedging the risk created by currency volatility. Therefore, a fit-for-purpose strategy that effectively manages this uncertainty while supporting overall financial objectives must be customised, flexible, and aligned with the insurer’s overall business strategy.

• Customized. Customization ensures the hedging strategy is tailored to an insurer’s specific risk profile and business model. This requires an understanding of requirements, commercial context, and risk appetite. With this knowledge, insurers are well-equipped to create agile solutions that reduce risk by applying appropriate currency tools and contracts.
• Flexible. For a hedging strategy to be effective, it must be flexible enough to adapt and evolve in line with the dynamic business environment and changing currency market conditions. This demands regular performance reports and currency market insight, allowing insurers to understand their market exposure and adjust accordingly.
• Aligned. Ensuring alignment with overall financial and operational strategies underpins a successful hedging strategy integration. This helps to bridge the gap between the business and an insurer’s strategy for a holistic approach to currency risk management that mitigates financial volatility and drives profitability.

Ensuring a Current Hedging Strategy

Hedging strategies can quickly become out of date amid changing currency market conditions and business needs. A rigid strategy that fails to adapt to higher levels of currency volatility or shifting operational requirements can leave insurers vulnerable to heightened currency risk.

For insurers to ensure that their strategy remains current, it must be regularly reviewed and updated — a kind of FX health check. This vital assessment of currency risk exposures provides an ongoing performance and goal assessment, allowing for revisions as necessary.

To be accurate and to add value, this process of strategy monitoring and adaptation requires access to real-time data. This can be facilitated by a currency specialist, who will leverage powerful technology to provide the right data when necessary, empowering informed decisions without delay. For instance, artificial intelligence algorithms collect and analyze vast live currency market datasets that can be used to back-test the strategy. Armed with this ongoing insight, insurers can ensure their strategies’ effectiveness amid the dynamic variables that have the potential to erode their value.

The Final Word

Insurers that react in the face of currency volatility or rely on questionable forecasts lack the resilience and agility needed to mitigate associated risk. By adopting a proactive approach to currency risk management, insurers can customize a hedging strategy that shields overseas revenues and investments from volatility and is flexible enough to consistently adapt to dynamic economic and business conditions. To achieve strategic fit for purpose, insurers should select the right currency partner to help them develop, execute, and monitor a bespoke strategy that’s aligned to their unique risk appetite. When empowered by a customized, flexible, and aligned strategy, insurers can elevate their businesses by enhancing financial stability and operational efficiency, and by focusing on their primary mission: to provide clients with financial protection and risk management in a world of ongoing uncertainty.

To learn more about the Sapiens/Lumon partnership, click here.

[1] Allianz Global Insurance Report: Navigating Growth and Challenges in a Rapidly Changing World