url
15
Apr
2014

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: INTRODUCTION

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: INTRODUCTIONTaiwanese insurance firms have been authorized to engage in derivatives activities since the mid-1990s although the insurance regulator only permits the use of derivatives for hedging purposes and not for speculative purposes. However, very few insurers were actively involved in this market prior to 2001. Table 1 shows that the number of derivative users and the value of derivatives held by the Taiwanese insurance industry increased substantially during the period 2001-2003, with life insurers being the main users. This finding is consistent with Cummins, Phillips, and Smith for the U.S. market and De Ceuster et al. for the Australian market, who find that derivative use in the non-life insurance sector is relatively low and that derivative activity is limited almost exclusively to the life sector. As shown in this table, the number of derivative users and their derivative holding increase substantially over the sample period. There were 21% (0%), 36% (11%), and 67% (25%) of life (non-life) insurers that use derivatives in the years 2001, 2002, and 2003, respectively. In our analysis, if an insurer reports a non-zero derivative position, it is classified as a derivative user. It is possible, however, that some insurers may close out their derivative positions, thus appearing not to be derivative users. According to the year books and annual financial reports provided by the Insurance Institute of the Republic of China, Taiwanese derivative users in the insurance industry tend to use foreign currency contracts.

Non-life insurers only utilize currency forwards and for life companies they are the most popular type of contract in terms of number of users and positions held. Specifically, 67%, 80%, and 84% of life sector derivative users utilized currency forwards in 2001, 2002, and 2003, respectively. In terms of notional amounts of contracts, currency forwards accounted for 42%, 48%, and 48% of end-of-year derivative positions in 2001, 2002, and 2003, respectively. According to these users’ financial statements, currency forwards are utilized to hedge currency risk arising from foreign investments or other operations. Interest rate swaps also account for significant end-of-year volume in the life sector. Although none of the life insurers used interest rate swaps in 2001, these contracts accounted for 22% and 40% in 2002 and 2003 respectively. Our results are consistent with Heaney and Winata who find that currency forward contracts and interest rate swaps are the most popular types of derivative contracts used by large Australian firms.
There are three main lines of research relating to corporate use of derivatives in the literature. The first concerns the practices of corporate derivative use. These studies focus mainly on a descriptive analysis of derivative practices such as the number of companies employing derivative securities and the volume of trades. The second investigates the factors influencing the participation and volume decisions on derivative use. These papers attempt to identify the motivation for participating in derivative markets and the factors affecting the extent of their use. The last line of research examines the effect of derivative use on firm risk. These studies attempt to ascertain whether firm risk increases or decreases with the use of derivatives. there
This paper focuses on the second line of research – the determinants of derivative use in terms of the participation and extent of use decisions. We provide evidence from an emerging market which complements the existing US literature.

Table-1. Number of Insurers in Life and Non-Life Sectors

2001 2002 2003 Total
Life insurers using derivatives Life insurers in our sample 627 1028 1924 3579
Life insurers in business 29 28 27 84
Non-life insurers using derivatives Non-life insurers in our sample 0 (0)2 324 624 971
Non-life insurers in business 28 27 24 79

Taiwanese insurance firms have been authorized to engage in derivatives activities since the mid-1990s although the insurance regulator only permits the use of derivatives for hedging purposes and not for speculative purposes. However, very few insurers were actively involved in this market prior to 2001. Table 1 shows that the number of derivative users and the value of derivatives held by the Taiwanese insurance industry increased substantially during the period 2001-2003, with life insurers being the main users. This finding is consistent with Cummins, Phillips, and Smith for the U.S. market and De Ceuster et al. for the Australian market, who find that derivative use in the non-life insurance sector is relatively low and that derivative activity is limited almost

About The Author

Kevin J. Brandon

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