HSBC 2015 Annual Report Download - page 223

HSBC HOLDINGS PLC
221
Strategic Report Financial Review Corporate Governance Financial Statements Shareholder Information
Categories of guaranteed benefits
• implicit interest rate guarantees: when future policyholder benefits are defined as fixed monetary amounts, e.g. annuities in payment
and endowment savings contracts;
• 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. Where the foreign exchange exposure associated with
these assets is not hedged, for example because it is not cost effective to do so, this exposes the subsidiary to the risk of its
local currency strengthening 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
fees earned for management are related to the market value of the linked assets.
Asset and liability matching
It is not always possible to match 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 forecast
payment dates of liabilities may exceed the duration of the longest dated investments available.
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 to best structure asset holdings to support liabilities. The scenarios include
stresses applied to factors which affect insurance risk such as mortality and lapse rates. Of particular importance is assessing
the expected pattern of cash inflows against the benefits payable on the underlying contracts, which can extend for many
years.
How market risk is managed
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 may 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;
• structuring asset portfolios to support projected liability cash flows;
• using derivatives to protect against adverse market movements or better match liability cash flows;
• 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;
• designing new products to mitigate market risk, such as changing the investment return sharing portion between policyholders and the
shareholder;
• exiting, to the extent possible, investment portfolios whose risk is considered unacceptable; and
• repricing premiums charged to policyholders.
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. Management reviews certain exposures more frequently when markets are more
volatile to ensure that any matters arising are dealt with in a timely fashion.