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How can the insurance industry adapt to mounting FX challenges?
27 March 2023
The insurance industry has gone through a period of significant change over the past twelve months. Against a backdrop of rising inflation, ongoing supply bottlenecks, geo-political conflict and climate-induced disruption, insurance firms have had to adjust their operational practices to meet the demands of this challenging environment.
Amongst the growing number of challenges facing insurers is the task of foreign exchange (FX) risk management. Insurance firms are in fact responsible for a significant amount of FX trading. The 2022 BIS Triennial Bank Survey found that ‘other financial institutions’ such as insurance companies were responsible for $3.6 trillion in trading volumes, representing 48% of global turnover.
Despite this, insurance companies typically transact in FX not because they want to, but because they have to, given their global coverage and the subsequent requirement to pay out claims in different currencies.
However, with the market facing headwinds across a range of different fronts, it is vital that insurance companies have effective FX risk management strategies in place to mitigate the impact of currency exposures and an increasingly uncertain trading environment.
What are the FX challenges for insurers?
The past year has thrown up a host of new challenges for the insurance market, with the industry facing a variety of pressure points and risk factors. These include:
- Inflationary pressures – Inflation has become a dominant economic trend, at times reaching 40-year highs across the UK and US. The cost of insurance claims and premiums has risen in line with inflation, meaning claims inflation and increased operating costs are now a real issue for underwriters.
- Supply chain disruption – Manufacturers continue to struggle to meet post-pandemic demand, with major trade hubs such as US ports being clogged up by bottlenecks due to a lack of staffing and equipment. A potential knock-on effect of backlogs and delays is longer interruption periods, which may put business interruption indemnity periods and sums insured under increasing strain.
- Catastrophe pay outs – Natural disasters caused an estimated global insured losses of $130 billion in 2022 – up from $112 billion in 2021. And if the summer of 2022 taught us anything, it is that global warming and subsequent extreme weather are here to stay. As this trend continues, catastrophe pay outs are also likely to carry on rising.
Furthermore, when an insurance company receives new premiums that it wishes to invest in foreign assets, it tends to enter into a foreign exchange swap if it wishes to reduce the exchange rate risk this investment will entail. This, combined with the aforementioned factors, is heightening the exposure of insurance firms to FX risk.
How can insurers improve their FX risk management strategies?
With FX volatility set to persist throughout the year ahead, we believe insurance companies must consider implementing a robust risk-management strategy to minimise their exposure to foreign currency movements.
Fortunately, there are a number of steps that insurers can take to achieve this:
1. The use of Transaction Cost Analysis (TCA) – TCA was specifically created to highlight hidden costs and enables insurers to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.
2. Compare the market - having the ability to put trades up for competition is central to ensuring access to the best price – which is key to effective risk management. However, many insurance firms are hampered by their inability to access Tier 1 FX liquidity, meaning they often rely on a single bank or broker to meet their hedging requirements. A new generation of fintechs is tackling this problem, enabling insurers to access rates from multiple banks whilst reducing the operational burden associated with this kind of market access.
3. Outsourcing - There is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities, but when using the right partner can improve transparency and execution quality. Outsourcing can enable insurance firms to dedicate more time to core business matters, which is all the more important amidst inflationary and volatility pressures.
4. Strong governance - Merger and acquisition activity in the global insurance industry has increased in recent months, recently reaching the highest growth rate for 10 years in the first half of 2022. It is therefore difficult to increase transparency and meet industry best practices due to each business having different partnerships and processes. To strengthen governance, insurance firms should look to FX solutions which help improve the cost, quality and transparency of their FX execution.
How MillTechFX can help
We believe insurers should get the right processes in place now to help manage FX operations more effectively and tackle the challenges that lie ahead.
MillTechFX by Millennium Global is the FinTech affiliate of Millennium Global Investments, one of the largest specialist currency managers globally. Our FX-as-a-service model helps insurance firms significantly reduce both FX costs and operational burden associated with FX execution and rolling hedging requirements.
We provide an end-to-end solution, from onboarding with up to 15 counterparty banks to execution, settlement and reporting of FX transactions, including TCA, across multiple funds.
To find out more about how we can help you navigate your FX challenges in 2023, get in touch with us here.