HSBC 2010 Annual Report Download - page 166

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Risk > Risk management of insurance operations > Financial risks > Market risk / Credit risk
164
We use models to assess the effect of a range of
future scenarios on the values of financial assets and
associated liabilities, and ALCOs employ the
outcomes in determining how the assets and
liabilities should be matched. The scenarios include
stresses applied to factors which affect insurance
risk such as mortality and lapse rates. Of particular
importance is matching the expected pattern of cash
inflows with the benefits payable on the underlying
contracts, which can extend for many years.
Our current portfolio of assets includes debt
securities issued at a time when yields were higher
than those observed in the current market. As a
result, yields on extant holdings of debt securities
exceed those which may be obtained on current
issues. We reduced short-term bonus rates paid to
policyholders on certain participating contracts to
manage the immediate strain on the business. Should
interest rates and yield curves remain low for
prolonged periods, further such steps may be needed.
How market risk is managed
(Audited)
All our insurance manufacturing subsidiaries have
market risk mandates which specify the investment
instruments in which they are permitted to invest and
the maximum quantum of market risk which they are
permitted to retain. They manage market risk by
using some or all of the techniques listed below,
depending on the nature of the contracts they write.
Techniques for managing market risk
• for products with DPF, adjusting bonus rates to manage the
liabilities to policyholders. The effect is that a significant
portion of the market risk is borne by the policyholder;
• as far as possible, matching assets to liabilities;
• using derivatives to a limited extent;
• for new products with investment guarantees, considering
the cost when determining the level of premiums or the
price structure;
• periodically reviewing products identified as higher risk,
which contain investment guarantees and embedded
optionality features linked to savings and investment
products;
• including features designed to mitigate market risk in new
products, such as charging surrender penalties to recoup
losses incurred when policyholders surrender their policies;
and
• exiting, to the extent possible, investment portfolios whose
risk is considered unacceptable.
In the product approval process, the risks
embedded in new products are identified and
assessed. When, for example, options and guarantees
are embedded in new products, the due diligence
process ensures that complete and appropriate risk
management procedures are in place. For all but the
simplest of guaranteed benefits the assessment is
undertaken by Group Insurance Head Office.
Management reviews certain exposures more
frequently when markets are more volatile to ensure
that any matters arising are dealt with in a timely
fashion.
How the exposure to market risk is measured
(Audited)
Our insurance manufacturing subsidiaries monitor
exposures against mandated limits regularly and
report them to Group Insurance Head Office.
Exposures are aggregated and reported on a
quarterly basis to senior risk management forums in
the Group, including the Group Insurance Market
and Liquidity Risk Committee, Group Insurance
Risk Committee and the Group Stress Test Review
Group.
Standard measures for quantifying market risks
• for interest rate risk, the sensitivities of the net present
values of asset and expected liability cash flows, in total and
by currency, to a one basis point parallel shift in the
discount curves used to calculate the net present values;
• for equity price risk, the total market value of equity
holdings and the market value of equity holdings by region
and country; and
• for foreign exchange risk, the total net short foreign
exchange position and the net foreign exchange positions by
currency.
The standard measures are relatively
straightforward to calculate and aggregate, but they
have limitations. The most significant one is that a
parallel shift in yield curves of one basis point does
not capture the non-linear relationships between the
values of certain assets and liabilities and interest
rates. Non-linearity arises, for example, from
investment guarantees and product features which
enable policyholders to surrender their policies. We
bear the shortfall if the yields on investments held
to support contracts with guaranteed benefits are
less than the investment returns implied by the
guaranteed benefits.
We recognise these limitations and augment our
standard measures with stress tests which examine
the effect of a range of market rate scenarios on the
aggregate annual profits and total equity of our
insurance manufacturing subsidiaries, after taking
into consideration tax and accounting treatments
where material and relevant. The results of these
tests are reported to Group Insurance Head Office
and risk committees every quarter.
The following table illustrates the effects of
various interest rate, equity price, foreign exchange
rate and credit spread scenarios on our profit for the
year and total equity of our insurance manufacturing
subsidiaries: