The Taiwan Banker

In early May, the Taiwan dollar surged from 32 to below 30 against the USD in just two trading days. This appreciation hammered life insurers holding large amounts of USD-denominated assets, triggering massive unrealized losses of stable book value. Appreciation by itself is not good or bad, but a sudden market downturn like this one can catch life insurers off guard before they can adjust their hedging strategies, leading to large short-term fluctuations in reported balance sheets.Life insurance is mainly a retirement savings vehicle, in contrast to property insurance. typically hedge currency risk via currency swaps (CS), as well as non-deliverable forwards (NDF) for quick, short-term adjustments. This strategy, coupled with a dynamic reserve system tied to exchange rate movements, has effectively mitigated the impact of New Taiwan dollar fluctuations in recent years, but the effectiveness of this system hinges on two key assumptions: manageable hedging costs and ample market liquidity. For years, life insurers' hedging costs remained manageable, typically between 1% and 2.5% annually, as long as interest rate differentials were not wildly skewed.But the dramatic appreciation in May triggered a massive spike in short-term hedging needs.NDF prices skyrocketed, and counterparty banks slashed their limits, refusing large life insurance hedge positions and demanding higher premiums.Some insurers reported difficulty securing sufficient hedging tools even at inflated prices, making hedging costs unpredictable and reinforcing market expectations of further New Taiwan dollar appreciation. More importantly, exchange rate derivatives have a price discovery mechanism.NDF prices reflect market expectations of the NTD rate.High demand for hedging instruments drives up NDF prices, implying NTD appreciation. This creates a self-reinforcing cycle: NTD appreciation increases hedging demand among insurers, raising hedging costs, which further fuels expectations of NTD appreciation, attracting more capital and accelerating the appreciation. This is not just a market fluctuation; a long squeeze is a positive feedback loop within the financial system, posing a systemic risk. Should the New Taiwan dollar break through the NT$29 per US dollar mark, life insurance companies risk completely exhausting their accumulated foreign exchange reserves.While a sound mechanism, these reserves function as a limited buffer against exchange rate fluctuations.Their depletion would expose insurers to the full force of these fluctuations, leading to volatile net profits and impacting their risk-based capital (RBC) adequacy ratio, shareholder equity, market sentiment, and credit ratings.A widespread impact across multiple insurers could pose a systemic risk to financial stability. The government needs to consider whether the life insurance industry's hedging activities could trigger irrational exchange rate volatility.Failure to intervene promptly could trap Taiwan's financial market in a self-fulfilling prophecy in which price expectations dictate reality, eventually harming the real economy.Possible responses include creating a life insurance hedging quota auction, encouraging longer-term hedging strategies (CS instead of NDFs), and managing the release of hedging demand to prevent market crashes.Temporarily increasing flexibility in foreign exchange reserves could also provide short-term relief.Another looming threat is the potential impact of the pending “reciprocal” tariffs on global trade and capital flows.Should the US impose high tariffs, Taiwan’s export structure and foreign exchange market could be significantly altered. This increased uncertainty makes long-term New Taiwan dollar forecasting extremely challenging, forcing a shift in hedging strategies from passive reaction to proactive management of multiple risks.Cross-departmental collaboration will be crucial to model various scenarios based on the unpredictable nature of Trump-era policies, enabling diversification of risk mitigation and capital buffer strategies.Facing significant market uncertainty and volatility, the insurance industry must act decisively.This includes more transparent and timely hedging disclosures to provide market clarity on risk exposure, as well as improved asset-liability matching, leveraging dynamic asset allocation and technology, to lessen dependence on short-term hedging.Furthermore, collaboration among large insurers through joint hedging negotiations or strategic alliances will enhance their bargaining power and mitigate the effects of price swings.Finally, regulatory oversight must be strengthened to monitor hedging practices, identify potential systemic risks stemming from coordinated actions, and enable preemptive responses.This episode serves as a stark warning:well-intentioned hedging can spiral into uncontrollable systemic risk due to flawed regulations and capital pressures.Proactive collaboration between the government and industry to develop new mechanisms and emergency protocols will be crucial to prevent and mitigate future crises.Linus Chan is professor of financial engineering at Soochow University and CEO of the Insurance Institute of Taiwan