This week is about hedging in the insurance industry. However, since the topic is quite technical, I’ve asked for the help of @actuariallyme with this. Thank you!
There are many risks that an insurer needs to hedge, such as interest rate risk, underwriting risk, equity risk, foreign currency risk, credit risk and many more. Among the many derivative instruments used in the insurance industry for hedging, swaps and options are the most widely used. We explore two commonly used hedges by life insurers.
Interest rate swaps are the most common swap derivative instruments used by insurers in their hedging strategies. For example, life insurers that offer interest rate guarantees on their life savings products often use the premiums to purchase assets to generate income. The income is variable, and if interest rates fall, the asset returns would fall too, and the risk is that these returns aren’t enough to meet the guaranteed amount. Hence, the hedge could allow the insurer to swap its variable income with a fixed one, hence be able to meet the guarantee.
Another example is the call option, where the insurance company has the right, but not the obligation, to buy an asset (maybe a stock) for a specific price, called the strike price, at a later date. So, if the stock price increases, the insurer will benefit as they only need to pay the strike price amount.
The above describes very briefly just 2 ways a life insurer can hedge against their market risks. A general insurance company would have other bigger risks to consider, such as underwriting risk – and they would use reinsurance heavily as a hedge (stay tuned for a later blog about this). There are also many other hedges and risks insurers need to consider – feel free to DM me or @actuariallyme if you want to discuss these in more detail!
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