BNP Paribas recently published a report on convexity risk, contact your BNP Paribas sales representative for the full report, and discover our Rates business.
As interest rates continue to fall, insurers are facing a growing concern that’s been lurking in the shadows in recent years: convexity. This complex phenomenon refers to the way that small changes in interest rates can have a disproportionately large impact on an insurer’s balance sheet. This in turn threatens solvency, consumes capital, and erodes profitability for both policyholders and shareholders.
Despite current market expectations of a soft landing (a gradual slowing of economic growth without entering a recession) there are several headwinds blowing against economic growth, making further rate declines a very real possibility. While lower rates increase the convexity dilemma, the answer lies in turning risks into opportunities. Insurers are taking advantage of current market conditions – offering relative value for hedging – to boost their convexity protection.
The root of convexity
Convexity is a risk measure reflecting the rate at which the duration of assets, or liabilities, changes as interest rates change. In simple terms, it refers to the sensitivity of a portfolio’s duration to changes in interest rates.
Convexity is a particular issue for insurers. Exposure originates mainly from two common market practices:
Mismatch between assets and liabilities
Life insurers guarantee to pay policyholders a certain amount of money in the future, for example 10 or 20 years. This is a long-term commitment and considered a liability. However, the problem is that most assets available in the market, such as bonds, tend to have shorter tenors, meaning they mature in a shorter period, i.e. 5-7 years. Insurers favour assets with shorter tenors as they tend to offer higher yields. This, however, creates a mismatch between the cash flows of assets and liabilities. Liabilities are long-term, but assets are short-term, exposing insurers to interest rate risk.
Another challenge is that matching cashflows between assets and liabilities can be a complex task, requiring sophisticated investment strategies and risk management techniques.
In addition, some insurers also take directional views on interest rates, hoping to profit from higher long-term rates (known as the term premium). This means they might intentionally not match their cashflows, anticipating that interest rates will rise in the future.
Contractual optionalities sold to policyholders
General account contracts often come with minimum return guarantees and capital guarantees. Essentially, policyholders are purchasing rates options from insurers, which pose a potential risk for insurers if the rate falls below the guaranteed rate. For example, between 2014-2021, falling market rates dragged the book yield below the guaranteed rate, triggering profitability and solvency issues.
As a result of these practices, assets and liabilities are often mismatched, naturally exposing insurers to convexity risk. Therefore, this risk must be carefully managed.
Hedging against convexity
Convexity hedging is a risk management strategy used by insurers and other financial institutions to mitigate the potential risks that can arise from convexity. One example involves taking positions in financial instruments that have a negative correlation with the convexity of the assets or liabilities being hedged.
Hedging against convexity can provide several benefits including, interest rate risk management, capital adequacy, protecting against solvency risk and adhering to regulatory requirements.
However, left unmanaged, it has the potential to impact insurer’s balance sheet, threaten solvency, consume capital, and erode profitability. While insurers are naturally exposed, effective hedging strategies can help to mitigate risk.
BNP Paribas recently published a report on convexity risk, contact your BNP Paribas sales representative for the full report, and discover our Rates business.
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