Insurers embrace derivatives for long-term resilience

Asian insurers are steadily broadening their use of derivatives, moving from tactical hedging into more sophisticated applications that underpin long‑term portfolio construction.

Richard Chan

Prudential

“Derivatives are not the only tool, but they are an essential one for managing capital volatility behind the scenes, enabling insurers to remain long‑term investors and contribute to sustainable returns and the real economy,” Richard Chan, chief investment officer at Prudential Bermuda, said at AsianInvestor’s Insurance Investment Briefing in Hong Kong on September 15.

Chan began his career by moving from actuarial work into investments, where his first task was to design a derivatives framework. At the time, usage in Hong Kong was limited, but he noted that adoption has since grown significantly, with derivatives now a common tool for portfolio management.

Their role, he said, has expanded beyond asset management into bridging gaps in asset‑liability management and enhancing capital efficiency.

He outlined how institutional investors should approach specific risks. For interest rate hedging, “the most effective tools are interest rate swaps and bond forwards. If I need to hedge a 10‑year reinvestment risk, my go‑to instrument is the interest rate swap, which has a longer available forward tenor. On the other hand, bond forward offers a less operational burden.”

Currency hedging, he added, depends on duration. “FX forwards are more suitable for hedging short-duration assets, while cross-currency swaps work better for longer duration exposures,” Chan said.

Equity exposures are more complex, since index hedges rarely align with actively managed portfolios. “It’s more effective to hedge ETFs or systematic strategies first, while leaving active positions partially unhedged or managing them stock by stock,” he said.

The choice between delta‑one instruments and options hinges on volatility dynamics, with options offering stronger protection in stress scenarios and more favourable capital treatment.

Chan also emphasised derivatives’ role in portfolio efficiency. Using derivatives for efficient portfolio management normally means taking well-diversified risk.

“In my own experience, that has included selling credit default swap index protection to build a well-diversified bond portfolio, or employing total return swap overlays to replicate equity exposures such as ETFs,” he said. These strategies, he noted, improve diversification, enhance liquidity and preserve government bonds that can serve as collateral.

Swaptions, though less common in Asia, are another tool insurers should consider. Widely used in the US and Europe to manage tail risk and complex liabilities, they remain nascent in Asia. Chan said they are valuable for hedging complexity in participating products, where policyholders capture upside while shareholders absorb downside risks, but cautioned against using them to mask short‑term duration gaps.

Liquidity and collateral management, he said, remain central. “The problem arises when your hedge doesn’t perform while your underlying portfolio does—you face a negative mark to market and need to post collateral. You need to have the ability to measure the contingent liquidity need, maintain sufficient buffers, strengthen your credit support annex, or even use contingent repo facilities to convert less liquid assets into liquid ones when needed.”

His message was clear: derivatives are no longer peripheral tools but integral to insurers’ ability to manage volatility, build resilient portfolios, and remain long‑term investors in Asia’s evolving markets.