US Rate Hikes And A Tumbling Yen: Implications For Domestic Insurers In Japan

Rising Foreign Interest Rates, Declining Yen

Since March 2022, the US Federal Reserve has raised its target interest rate range six times, from just 0 per cent to 0.25 per cent to a range between 3.75 per cent to 4.0 per cent. The Japanese yen has since depreciated by over 25 per cent against the US dollar. The yen’s tumble is mainly due to policy divergence between the Fed’s aggressive monetary tightening (to curb headline inflation that has topped 8 per cent) and the Bank of Japan’s (BoJ) decision to keep interest rates ultra-low (e.g., -0.1 per cent target for short-term interest rates, and 0 per cent for the 10-year government bond yield) to support its economy and encourage wage growth.

Impacts Vary According To Asset-Liability Characteristics

Such policy divergence has not only widened the interest rate gap between Japan and the US, but also spurred buying of the US dollar, which offers higher interest rates, consequently leading to the sharp yen depreciation to a level not seen in more than three decades. While certain sectors of Japan’s economy grapple with climbing interest rates overseas and a weakening yen, the potential impact of this trend on domestic insurers might not be so straightforward, given varying features of their assets and liabilities.

Based on how Japan’s domestic insurers typically manage their risk exposures (especially the major players), the short-term impact on its life insurers is likely to be minor, while for non-life insurers, very limited.

Relative to most of Japan’s domestic non-life insurers, some life insurers underwrite a considerable amount of foreign currency denominated insurance policies, which are largely savings products. In addition, life insurance companies tend to have longer liability durations than asset durations and are typically more proactive in search of yield overseas, which gives rise to a greater sensitivity to foreign interest rate changes.

Evaluating Foreign Exchange Risk Exposures

In evaluating an insurer’s exposure to foreign exchange rate risk, a key consideration is its gross exposure, without considering any cost and benefit associated with the use of derivative instruments. For most insurance companies, gross exposure to foreign exchange rate risk mainly arises from: a) presence of currency mismatch between its policy liabilities and underlying assets; and b) appetite to invest a significant portion of its surplus capital in foreign securities as part of its strategic asset allocation.

The policy liabilities for Japan’s non-life insurers tend to be shorter in duration, so their tolerance for currency mismatch between their policy liabilities and underlying assets are generally very low. To back policy liabilities, such as reserves for unearned premiums or outstanding claims, most non-life companies prefer to hold highly liquid assets in local currency, such as cash and cash equivalents, deposits, and short-term investments, as part of asset-liability management. The less liquid or higher risk investments on their balance sheets, such as domestic equities, foreign securities, or corporate bonds, are typically associated with their surplus capital.

In the case of Japan’s life insurers, we typically consider their gross exposure to foreign exchange rate risk to be moderate. Although life insurers have policy liabilities and underlying assets that are denominated in foreign currencies, the extent of currency mismatch and/or residual foreign exchange rate risk are effectively limited by product design and investment allocations.

For example, policy liabilities of life insurers may be classified as:

• Foreign currency denominated policies, usually backed by foreign-currency denominated assets, and thus the foreign exchange rate risk retained by life insurers is very limited;
• Yen-denominated participating policies, where risks and returns are shared between policyholders and insurers, even with presence of material foreign exchange rate risk, any residual gross exposure for insurers would be limited by product design;
• And yen-denominated non-participating policies, either backed by yen-denominated assets and/or foreign currency denominated assets.

Of these three types, the greatest source of currency mismatch between policy liabilities and underlying assets is the case in which a portfolio with significant yen-denominated, non-participating policies are mainly backed by foreign currency denominated assets. However, we note that insurers in Japan typically do not prefer this asset-backing structure but prefer using yen-denominated assets to cover yen-denominated policy liabilities – effectively limiting the extent of currency mismatch on their balance sheets.

For both non-life and life insurers, rather than currency mismatch between policy liabilities and underlying assets, we believe that the largest source of Japanese insurers’ potential exposure to foreign exchange rate risk is their strategic allocations, especially those that reflect an appetite to invest a significant portion of surplus capital in foreign securities in search of yield. (Surplus capital is the amount of solvency capital in excess of regulatory minimum requirement.) Nonetheless, it is worth noting that foreign bond holdings among Japan’s insurers usually represent less than 200 per cent of surplus capital. Considering the potential for volatility in the foreign exchange markets (especially the USD to JPY exchange rate), it can be said that insurers’ foreign exchange exposures are generally considered manageable relative to both their regulatory solvency position and economic solvency position.

Unhedged Foreign Assets Or Lower Returns

Net exposure, which takes into account the costs and benefits associated with using derivatives, is another factor used in evaluating an insurer’s exposure to foreign exchange risk. The financial results of insurance companies with both low gross and net exposure to foreign exchange rate risk will generally be robust to withstand the increased volatility in foreign exchange markets. Conversely, companies with high gross exposure but low net exposure (using derivative instruments) may find their financial results more vulnerable to a surge in hedging costs.

The protracted low interest rate environment in Japan since the 1990s has placed significant pressure on insurers’ investment income for decades. This has led most companies to seek better interest yields through foreign bonds that offered potentially higher risk-adjusted returns more recently, especially in the past decade or so. We note that most insurance companies have an investment policy that aims to hedge at least 70 per cent of their exposures to foreign bonds, while others (especially non-life insurers) may hedge up to 100 per cent of their exposures. The use of derivative instruments effectively reduces their net exposures to a level equivalent to low single-digit percentage of their surplus capital or even total investment funds, even if their gross exposures are moderate.

However, heightened uncertainty in foreign exchange markets—most recently stemming from global inflation and subsequently the Fed’s aggressive policy moves—has weighed on Japanese insurers’ demand for foreign bonds given falling bond prices. Additionally, the BoJ remains firm on its commitment to monetary easing, widening interest rate gaps, while the yen continues to depreciate against the US dollar and hedging costs rise.

As the yen’s weakness and elevated hedging costs may persist for an extended period, most insurers have encountered difficult choices. These include to what extent insurance companies are willing and able to adopt riskier investment strategies in search of yield, mainly by taking on larger currency risks by increasing their unhedged or unprotected portion of foreign securities. Also, whether to take a more cautious approach to investing risk assets by accepting lower returns on currency-hedged foreign bonds or yen-denominated assets.

We note that most insurers in Japan are inclined to exercising caution when investing in riskier assets and have mainly shifted their focus from foreign bonds to domestic bonds. In fact, several have been less active in foreign bond purchases and have been net sellers of foreign bonds since the first half of 2022. At a minimum, this move has effectively ensured that their net exposures to foreign exchange risk can be maintained at conservative levels, while potential volatility in financial results remain manageable against the threat of a widening interest rate gap.

Concluding Remarks

In our view, the short-term financial impact of rising interest rates in the US, as well as the associated indirect effects (such as an accelerated weakening of the yen) has been limited for Japan’s insurers, mainly due to their low tolerance for currency mismatch on their balance sheet. Although there are some gross exposures arising from their strategic asset allocations, most insurance companies have limited the associated net exposures to a manageable level with derivative products, such as foreign exchange swaps and options.

Over the next 12 months, global inflationary pressures are likely to increase, subject to developments in the US and Europe, as well as the Russia-Ukraine conflict. The Fed is expected to continue with its aggressive monetary policy tightening to lower inflation. Given that inflation is a less pressing concern in Japan, and until it becomes certain that wages can increase as a trend (e.g., wage growth exceeding 2 per cent), the BoJ is likely to continue with its monetary easing policy. As such, the interest rate gap is unlikely to shrink anytime soon. As the interest rate differential increases, the yen-dollar exchange rate could swing sharply towards further yen depreciation, assuming that there is no effective and sustainable intervention by the BoJ in the foreseeable future.

These challenges are likely to dent the value of insurance companies’ foreign bond portfolio, and at the same time, lower the potential risk-adjusted returns from currency-hedged foreign bonds (due primarily to higher hedging costs). Amid such an investment climate, which has made the search for yields overseas more challenging, we are of the view that Japan’s insurers will continue to shift their investments from foreign bonds to domestic bonds (especially super-long dated Japanese government bonds), manage their product features (to reflect the prospective investment climate), as well as make more effective use of derivative products to manage net exposures. Apart from weathering the expected financial market volatility, some of these moves will also better prepare insurers for Japan’s new economic value-based solvency framework that is expected to be implemented in 2025.

Jason Shum
Jason Shum is an associate director at AM Best Asia-Pacific Limited in Hong Kong. He can be reached at jason.shum@ambest.com.