Using DFA for Modelling the Impact of Foreign Exchange Risks on Reinsurance Decisions

The fluctuations of the foreign exchange (FX) rates are a source of additional risk, but also an opportunity for further profits for internationally operating reinsurers. A DFA model that includes FX rates can be a means for measuring the potential impact of FX rate fluctuations on portfolios of ceded reinsurance and internationally invested assets. Moreover, such a DFA model can also be a means for testing different strategies for managing FX risk. We start by surveying the empirical properties of FX rate data and introduce some simple approaches for generating FX scenarios. We then study the different ways in which reinsurers are exposed to FX risk, and possible strategies for managing these risks. The emphasis is on so-called on-balance sheet currency hedging techniques, i.e. on offsetting FX risks on reinsurance contracts by investing appropriate amounts of money in the respective foreign currency. The theoretical reasonings are accompanied by a DFA study on an international loss portfolio. This study shows that FX fluctuations can have an impact on the reinsurer’s business, and that the optimal strategy may not be a full hedge depending on the type of business and on the economic circumstances.