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19
Apr
2014

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: RISK EXPOSURE

ON THE DETERMINANTS OF DERIVATIVE HEDGING BY INSURANCE COMPANIES: RISK EXPOSUREForeign Exchange Risk
Insurers with overseas business and foreign investment are exposed to foreign exchange risk. In Taiwan, insurers are required to manage risks on their open foreign exchange positions, including such items as overall exposure, individual dealer’s position, single transaction volume, stop loss protection strategy, and counterparty’s limits. As an alternative, insurers have gradually employed derivatives to manage currency risk. Thus, we expect that large currency exposure to provide risk managers with incentives to hedge using derivative contracts. The foreign exchange (FX) risk is measured by the value of foreign asset portfolios scaled by the book value of total assets.
Interest Rate Risk
Insurance firms with a high mismatch between duration of assets and duration of liabilities will be sensitive to changes in interest rates. Carson, Elyasiani and Mansur document the prevalence of insurer exposure to interest rate risk and the dissimilarity of interest rate exposure among life, property and casualty, accident and health insurers. They also argue that the differences in interest rate exposure may result from differential use of interest rate derivatives. We therefore expect a positive relationship between derivative hedging and the gap between asset and liability durations (Cummins, Phillips and Smith, 1997; De Ceuster et al., 2003). Moreover, Purnanandam finds that firms with higher likelihood of financial distress will aggressively manage interest rate risk using derivatives or on-balance sheet instruments. Following Colquitt and Hoyt and De Ceuster et al. , we measure duration gap as non-current asset duration less non-current liability duration, scaled by total assets (MISAST). The other related variable (MISLIA), non-current liability duration less non-current asset duration, scaled by total assets, is utilized to distinguish the type of duration gap affecting derivative use.
The second interest rate proxy (IM), measured by the net interest margin scaled by total assets, is also employed to capture the additional influence of interest rates on derivative use.
Substitutes for Risk Management
Corporations can avoid short-term insolvency risk by maintaining a high degree of liquidity (Nance, Smith and Smithson, 1993). Thus, insurers with higher current ratios (CR) should have less need for derivative hedging. Moreover, diversification across various types of claim payments might potentially reduce the demand for hedging instruments and, to some extent, serve as a substitute for the use of derivatives. In our analysis, the claim payments of life insurance are broadly classified into four types: life, accident, health and annuity, while those of non-life insurance are categorized into ten types: fire, hull, ship, inland marine, automobile, aviation, engineering, liability, credit and others. We utilize the Herfindahl index to measure the diversification of claim payments (HERFC).
Reinsurance is instrumental in managing underwriting and financial risks (Cummins et al, 1997) and the volatility of firm value can be decreased accordingly (Hardwick and Adams, 1999). Insurers relying heavily on reinsurance have less need for derivatives. We therefore expect a substitution effect in this hedging context. The use of reinsurance contracts (REINS) is measured by the ratio of reinsurance ceded to the sum of direct premiums written and reinsurance assumed.
Institutional ownership in Taiwan generally represents a long-term relationship between the holding institution and the underlying firm. Since close supervision by institutional shareholders can be considered a substitute for additional hedging activities, a negative association between derivative use and the level of institutional ownership is expected in our study. We measure the institutional ownership (CH) by the shareholding proportion of institutional shareholders. there

Foreign Exchange Risk Insurers with overseas business and foreign investment are exposed to foreign exchange risk. In Taiwan, insurers are required to manage risks on their open foreign exchange positions, including such items as overall exposure, individual dealer’s position, single transaction volume, stop loss protection strategy, and counterparty’s limits. As an alternative, insurers have gradually employed derivatives to manage currency risk. Thus, we expect that large currency exposure to provide risk managers with incentives to hedge using derivative contracts. The foreign exchange (FX) risk is measured by the value of foreign asset portfolios scaled by the book value of total assets. Interest Rate Risk Insurance firms with a high mismatch between duration of assets and duration of liabilities will be

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Kevin J. Brandon

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