Re/insurers are not as insulated from the foreign exchange markets as they would like to believe
There were few expectations in the currency markets that the meeting in early February in Boca Raton, Florida of finance ministers and central bankers from the G-7 richest economies would solve the problem of the sliding US dollar. Since July 2001, the dollar has fallen by 50% against the euro. A communique after the meeting stated that: "We affirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely and co-operate as appropriate. In this context, we emphasise that more flexibility in exchange rates is desirable for major countries or economic areas that lack smooth and widespread adjustments in the international financial system, based on market mechanisms." The markets replied with a raspberry and pushed the dollar down even further.European leaders have blamed the weak dollar on US deficit spending.Washington expects a budget deficit of over $520bn this year, some 5% of GDP, and deficits of more than $400bn are likely to continue beyond 2009. The Europeans believe that the dollar's decline has overburdened the eurozone economies as the euro's rise makes the region's exports uncompetitive.The US thinks the European economies are too over-regulated for their own good and that a strong currency could provide some medicine. In Boca Raton, both sides hoped that Asia - notably Japan, China and South Korea, which either peg their currencies to the US dollar or intervene to keep their own currencies low - would solve the problem by floating their currencies; the so-called "desirable" flexibility in exchange rates called for in the communique. But the smart money now believes that the dollar will fall even further.
SpectatorsAs the business world and economic policymakers miss a collective heartbeat at the prospect of an even weaker dollar, reinsurers are keeping cool, at least for the moment. "Basically, we are spectators," said Serge Cadelli, Chief Investment Officer at Converium in Zurich. "We don't anticipate anything, we never take currency bets, we don't play the euro against the dollar, and we take the view that we are not hedge funds." Reinsurers claim to minimise translation risk - the impact of exchange rates on home currency accounting - by matching the currencies for assets and liabilities.On the operational side this amounts to little more than prudent underwriting.But problems can arise with non-major currencies in developing countries."You have to ask: do you take any foreign exchange gains into account in your premium pricing?" said Bruno Meyenhofer, CEO of PartnerRe Global.But this impact is almost impossible to compute in marginal markets and any foreign exchange gains could be wiped out by inflation. So PartnerRe does not do this, Mr Meyenhofer said.
Marginal currenciesBut the definition of marginal currencies is a moveable feast. The currencies of commodity exporting countries, such as Australia, South Africa and Canada, have increased along with commodity prices. Most commodity prices are expressed in US dollars and tend to have an inverse relationship with the dollar, rising as the dollar falls. This has created a dilemma for Lloyd's underwriting agencies, which use only four base currencies, sterling, the euro, and US and Canadian dollars, in their accounts. "Quite a few people have lost money on Australian liability exposures, and those can get even worse," said Tony Hulse, a Partner at management consultantcy KPMG and responsible for the wholesale and reinsurance markets practice.Lloyd's agencies have an even greater problem; their three-year accounting cycle means they are refunding losses in devaluing dollars. An underwriting loss is paid for at one dollar level and then accounted for at a lower level. "You appear to lose twice," Mr Hulse observed.Currency hedging is not really a solution to this problem. The high costs of it and new accounting standards for derivatives have meant that many businesses even outside of the re/insurance sector are opting for currency matching. The ING Group registered a EUR76m loss due to currency fluctuations during the first nine months of 2003. This included the mitigating effect of a US dollar hedge of EUR83m after tax. The new hedge accounting standard, IAS 39, requires companies to mark derivative values to market all the time, and to test their effectiveness. The whole transaction can become overcomplicated if a company, already facing liabilities greater than assets, takes out a financial instrument which in effect freezes future premiums, themselves difficult to estimate, said Mr Hulse. It becomes a game of smoke and mirrors. "Accounting is not about intentions or forwards, it's about what you've got," he said.
Shareholders' equityThe impact of currency fluctuations on re/insurers' costs and shareholders' equity has been mixed. In the case of PartnerRe, which accounts in US dollars, some administrative costs in Swiss francs have a minimal impact."Management expenses for a reinsurance company are in the single digit percentage range, so any foreign currency impact within that cost base is within one or two percentage points, not a big blow in anybody's account," Mr Meyenhofer said. But companies which conduct over half their business in dollars while reporting in euros face a tough balancing job. In its third quarter 2003 results, French reinsurer SCOR reported the group's shareholders' equity at EUR629m, compared with EUR1.07bn at end-December 2002.The company said that this was due to the fall against the euro in the main currencies in which SCOR conducts its business, representing an impact of EUR85m and a loss for the period of EUR349m euros.Munich Re appeared to do better over the period. Shareholders' equity increased to EUR14.9bn over the third quarter 2003, and was more than the EUR13.9bn registered at end-2002. Munich Re said in a statement that this was due to successful underwriting and the appreciation in value of its investments, which offset the negative impact of the strong euro. But even this is a substantial fall from the EUR19.36bn in shareholders' equity the company registered at end-2001. Catastrophe losses of that year masked its impact.So far, credit rating agencies have taken a benign view of the currency fluctuation impact on re/insurers. "Most insurers are fairly well matched as far as balance sheets are concerned," said Rob Jones, insurance analyst at Standard & Poor's in London. But Tony Hulse was more circumspect. People do not pay too much attention to the fact that the value of Munich Re's US business has fallen. If a foreign exchange loss drops out of a profit and loss account or shareholder funds, it gets noticed. "But if the ratio of book to market value goes down, it's a hidden problem," Mr Hulse added.
EarningsStock market analysts are monitoring currency fluctuations' impact on earnings per share. A JP Morgan research note in January estimated that the weak dollar will cause an 8.5% drop in 2004 earning per share for Aegon. The company derives two-thirds of its earnings from the US. In its 2002 annual report, Aegon estimated that a 10% change in the US dollar against the euro would result in a 5.5% to 6.5% move in earnings and a 10% to 11% impact on shareholders' equity. In the case of Swiss Re, JP Morgan expects a 7% decrease in 2004 net profits and a 17.7% drop in earnings per share because of the dollar fall. According to JP Morgan, companies have hedged some of their 2004 dollar exposure but none have hedged for 2005. But this would be an extra gamble for them to take, commented Roger Doig, insurance analyst at JP Morgan Securities.
Interest ratesReinsurers think that one of the big upcoming issues is what will happen to US interest rates. These are at 1% compared with 2% in the case of the European Central Bank (ECB). At the moment it makes no sense to shift to the US dollar, but future decisions will depend on US Federal Reserve Board strategy. A statement following a January meeting of a Federal Reserve Board policymaking committee did not include the phrase "considerable period" when referring to how long the Fed intended to be neutral on interest rates, and instead substituted a phrase about its "willingness" to be patient. This was interpreted in the money markets as a hint that the Fed would raise interest rates sometime in 2004 or early 2005 at the latest.Wall Street financiers have tended to assume that the Fed would not change interest rates for some six months ahead of a presidential elections to avoid giving the appearance of political manipulation. So far, purchases of US debt by Japan's central bank have played a major part in keeping US interest rates low.Swiss Re chief economist Kurt Karl said that although the Fed statement increases the risk of an interest rate hike in May or June, as long as US productivity reduces inflation, the Fed could hold back through the year. But Swiss Re thinks that the ECB could raise interest rates later in 2005. By contrast, if euro economies remain fragile and the euro continues to strengthen, the ECB could cut rates this year.
CrisisThough some reinsurance companies have bet successfully on interest rates, PartnerRe has no intention of playing the currency or interest rate game, said Mr Meyenhofer. Nevertheless, there is concern that the present currency volatility could develop into a global economic crisis and an increase in inflation. The impact on emerging markets in Latin America and Asia would be similar to the 1990s when regional currency crises led to delays in major projects, and less insurance and reinsurance turnover in engineering, energy, credit and surety, as well as triggering numerous political risk insurance losses.A Swiss Re sigma study on the lessons learned from financial crises in emerging economies note that the potentially volatile environment had to be taken into account when designing insurance products. It recommends shorter contract periods, inflation indexing, stringent claims control, stability clauses in reinsurance contracts, as well as life insurance contracts, where the insured shares the investment risk. But such advice is of limited value in a country like Argentina, where inflation-indexing is no longer permitted and the dollar-denominated life insurance market collapsed once the Argentine peso's peg to the US dollar was removed.
ComplicationsThe embrace by the US and Asian economies of deficit spending, in the case of the former, and printing money, in the case of the latter, has raised the 1980s' spectre of recession and hyperinflation which commentators called "building a highway to Buenos Aires", a reference to the Argentine 4,000%-plus inflation at the time. Reinsurers do not want to contemplate this "doomsday scenario" at the moment. But already some investment bankers, such as Morgan Stanley's Joachim Fels, are saying that as each country acts in what it perceives to be its own national interest, the notion that the euro could fall apart is not implausible. Conventional wisdom in the US money markets states that all the imbalances could be reconciled without too much pain. But with or without currency matching, re/insurers could be in for a bumpy ride.Maria Kielmas is a freelance journalist and consultant.