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May
2014

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: CONCLUSION

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: CONCLUSIONMost coefficients are positive and significant in the probit estimation but insignificant in the panel results. This suggests that although derivative utilization is gradually being accepted by insurance companies in Taiwan, the values of derivative contracts have not evolved in line with assets or revenues. Evidently, the informational economies or economies of scale do not occur among large Taiwanese insurance corporations as there are no significant differences between large and small firms in the extent of usage. This finding is consistent with the study on Taiwanese listed firms undertaken by Shu and Chen.
This article examines the relationships between the use of derivatives for hedging purposes and firm-specific factors. Most prior studies on the use of derivatives employ samples for a single year and from a particular industry. This paper extends the literature by studying two Taiwanese insurance sectors over a period of years.
The insurance data are hand-collected from annual financial statements of both life and non-life insurers. The period of observation is from 2001 through 2003. Using panel data and cross-sectional estimations, we investigate the participation and volume decisions on derivative contracts by Taiwanese insurance firms. A number of hypotheses are formulated and tested. The main results include:
Exposure to foreign exchange risk is positively and significantly related to derivative use (in terms of both participation and extent decisions) for both the life and non-life sectors. This indicates that insurance companies engage in currency risk management with derivative instruments.
The coefficient for the firm size variable is positive and significant in the participation decision model for the life sector. This finding supports the notion that informational economies and economies of scale are more important than the costs associated with financial distress.
Life companies which are exposed to interest rate risk due to the duration of non-current liabilities being greater than the duration of non-current assets, tend to use derivatives to manage the risk. The larger the duration gap, the more likely it is that the life company will use derivatives.
For non-life companies, there is a substitute relationship between reinsurance and derivative hedging. The greater the level of reinsurance, the lower the involvement in derivative activities. this
We believe that our findings have important implications for practitioners, stakeholders and regulators interested in risk management. For example, the prominent effects of informational as well as scale economies mean that larger insurers are more likely to employ derivative instruments than smaller insurers. Since the misuse of derivatives could increase the likelihood of financial distress, regulators and shareholders should closely monitor derivative activities, especially within large corporations. Also, currency risk is an important factor determining firms’ use of derivatives. Nevertheless, the range of derivatives that hedge currency risk is limited in the Taiwanese market.
With a view to providing firms with more alternatives, there is an urgent need for the development of further currency derivative products.
The interpretation of our findings should be tempered by two caveats. First, due to the regulatory requirements for derivative disclosure under current accounting standards, year-end notional value of derivatives positions are used as a measure of derivative usage throughout this paper rather than marked-to-market data that reflect the economic value of derivative contracts. Second, the results obtained from the panel data estimation may suffer from serial correlation of the error terms.

Most coefficients are positive and significant in the probit estimation but insignificant in the panel results. This suggests that although derivative utilization is gradually being accepted by insurance companies in Taiwan, the values of derivative contracts have not evolved in line with assets or revenues. Evidently, the informational economies or economies of scale do not occur among large Taiwanese insurance corporations as there are no significant differences between large and small firms in the extent of usage. This finding is consistent with the study on Taiwanese listed firms undertaken by Shu and Chen. This article examines the relationships between the use of derivatives for hedging purposes and firm-specific factors. Most prior studies on the use of derivatives employ samples for

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Kevin J. Brandon

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