Balancing International Insurance Portfolios and Exchange Risks

Abstract

This paper examines the balancing of the investment and liability portfolios of a (re)insurance firm operating in the international market. The model captures two effects which are ignored by traditional analysts.(a) According to the Interest Parity Theorem, the expected changes in the exchange rates should already be reflected in the expected rate of return on foreign investments. Therefore, an insurer operating in a perfect market should be indifferent to the currency denomination of its financial assets.(b) A second effect which has often been ignored is related to the additional risk resulting from the unexpected fluctuations of the exchange rates.The multi-index model suggested in this paper is capable of capturing these effects. The model can be used to examine and analyze alternative policies of the firm operating in international markets. For example, the model can be used to examine whether an insurer should take positions in certain currencies, or rather take a “full-hedge” policy.