HSBC 2011 Annual Report Download - page 208

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Risk > Appendix – Risk policies and practices > Insurance risk
206
Market risk
(Audited)
Description of market risk
The main features of products manufactured by our insurance manufacturing subsidiaries which generate market risk,
and the market risk to which these features expose the subsidiaries, are discussed below.
Interest rate risk arises to the extent that yields on the assets are lower than the investment returns implied by the
guarantees payable to policyholders by insurance manufacturing subsidiaries. When the asset yields are below
guaranteed yields, products may be discontinued. A list of the different types of guarantees within our insurance
contracts is outlined below.
Categories of guaranteed benefits
• annuities in payment;
• deferred/immediate annuities: these consist of two phases – the savings and investing phase and the retirement income phase;
• annual return: the annual return is guaranteed to be no lower than a specified rate. This may be the return credited to the policyholder
every year, or the average annual return credited to the policyholder over the life of the policy, which may occur on the maturity date or
the surrender date of the contract; and
• capital: policyholders are guaranteed to receive no less than the premiums paid plus declared bonuses less expenses.
The proceeds from insurance and investment products with DPF are primarily invested in bonds with a proportion
allocated to other asset classes in order to provide customers with the potential for enhanced returns. Subsidiaries
with portfolios of such products are exposed to the risk of falls in market prices which cannot be fully reflected in
the discretionary bonuses. An increase in market volatility could also result in an increase in the value of the
guarantee to the policyholder.
Long-term insurance and investment products typically permit the policyholder to surrender the policy or let it lapse
at any time. When the surrender value is not linked to the value realised from the sale of the associated supporting
assets, the subsidiary is exposed to market risk. In particular, when customers seek to surrender their policies when
asset values are falling, assets may have to be sold at a loss to fund redemptions.
A subsidiary holding a portfolio of long-term insurance and investment products, especially with DPF, may attempt
to reduce exposure to its local market by investing in assets in countries other than that in which it is based. These
assets may be denominated in currencies other than the subsidiary’s local currency. It is often not cost effective for
the subsidiary to hedge the foreign exchange exposure associated with these assets, and this exposes it to the risk that
its local currency will strengthen against the currency of the related assets.
For unit-linked contracts, market risk is substantially borne by the policyholder, but market risk exposure typically
remains as the market value of the linked assets influences the fees we earn for managing them.
Asset and liability matching
It is not always possible to achieve a complete matching of asset and liability durations, partly because there is
uncertainty over policyholder behaviour, which introduces uncertainty over the receipt of all future premiums and the
timing of claims, and partly because the duration of liabilities may exceed the duration of the longest available dated
fixed interest investments.
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.