Impact of FX policy on foreign currency denominated insurance policy
A foreign currency denominated insurance policies are special risks underwritten with the premium, sum insured or reinsurance recoveries and claims settlements payable in US dollar e.g. Energy risk insurance (Oil & Gas), Aviation risk insurance, Construction power project etc.
The above special risks are underwritten under a non-domesticated reinsurance treaty arrangement which requires extra capacity from abroad whereby the terms and conditions as well as rating of the policies are determined by the foreign reinsurers in the international Market.
The CBN new FX policy would have a direct impact on the (re)insurers in the sense that (re)insurance companies may likely pay more in claims on business underwritten in foreign currency, for example, Oil & Gas insurance transactions. This is because if the claim is to be paid in dollar, the underwriters will source for the dollar from interbank market using the current exchange rate which may be higher than when the business was incepted.
The above will also increase the reinsurance premium payable by the insurance companies to their foreign reinsurers because the premium is paid in foreign currency (dollar) and will be sourced for using the interbank exchange rate. However, where the whole insurance portfolio transactions are maintained in a foreign-currency account, the (re)insurance companies would need to increase their technical reserves provisions in order to accommodate future volatility in foreign currencies in the FX market.
The lack of local insurance firms to underwrite large risks, had paved the way for foreign insurers and brokers to undertake such activities, leading to loss of foreign earnings through capital flight. Thus, the currency fluctuation arising from the new floating FX policy would increase the capital flight if an insurer is underwriting more of these special risks.
The technical devaluation of naira through the CBN new FX policy would in the immediate shorter–term have a direct negative impact on the global rating of Nigeria insurance operators’ capital base. This is mainly due to the attendant increase in inflation rate and depreciation of domestic currency in the FX market, which result in the diminution of insurers’ total balance sheet values, particularly for the special risks portfolio, leading to a credit rating risk. Consequently, the local (re)insurers’ portfolios would become cheaper to acquire by investors. The (re)insurers would need to develop a defensive strategy against easy acquisition by strengthening their market risk solvency capital requirement which is part of the risk-based capital methodology being planned to be fully implemented by NAICOM in the near future.
A (re)insurer’s portfolio, consisting mainly of the special risks, operating under the CBN new floating FX regime is likely to be exposed to an economic risk which may arise where the long term currency movements can lead to fluctuations of (re)insurer’s future profits.
In the same vein, the (re)insurer will also be exposed to a foreign exchange translation risk which will impact on the Statement of Financial Position after conversion of foreign currency asset/liability values into local currency values.
In view of the foreign exchange rate risks highlighted above, an implementation of additional risk management requirements for a (re)insurer’s portfolio (with mainly special risks) will be of vital importance under the CBN new floating FX policy regime.
Additional risk management requirements under the new FX regime
It is clear that (re)insurance companies must certainly strengthen their respective (enterprise) risk management system in order to effectively manage the various risk exposures and impacts on their operations as a result of the CBN new FX policy regime.
At the elementary level, (re)insurance companies must ensure that their Foreign-currency (i.e. Domiciliary) Accounts are adequately maintained and funded to accommodate future claims payment in foreign denominated currencies. In this regard, (re)insurance companies must significantly reduce currency convertibility into local currency. In addition to the above, the (re)insurance companies can also engage in futures, forward exchange contracts and currency options as means of risk hedging.
Hedging in the futures market can be used to deflect the overall foreign exchange exposure in a desired direction. Thus, the introduction of the new products (e.g. futures and forward contract) in the new FX policy by CBN would give investors including (re)insurers the opportunities of hedging against the exchange rate risk by locking into the rate for future delivery of the foreign currency. These derivative products would help to reduce the volatility in the FX market. However, insurance regulation may not allow investors to trade in derivative instruments on a speculative basis.
The extent to which reinsurance treaties are expressed in local currency, regardless of the origin of the transactions concerned, will reduce some of the risks highlighted above, particularly for the economic and accounting risks.
For a reinsurer, a policy of diversification of foreign exchange exposure is capable of reducing the risk of producing a volatile future profit.
In conclusion, as much as the CBN new flexible FX policy regime would in no doubt stimulate economic growth over the longer term, it would significantly affect the stakeholders in the insurance industry differently. For example, consumer demands for insurance products, individual firm’s risk capital requirement and risk management systems etc. would be affected.
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