Modelling Foreign Exchange Rate Transaction Exposure of UK Insurance Companies: A Cash Flow-Based Methodology

Abstract

Purpose The purpose of this paper is to study the sensitivity of foreign exchange exposure through the cash flow estimation method using a sample of 59 UK insurance companies. This approach allows a decomposition of exposures into short- and long-term components. By revealing the nature of their cash flow exposures, companies can evaluate the effectiveness of their hedging programmes and focus their hedging efforts according to the nature of their exposures. Design/methodology/approach Martin and Mauer’s (2003, 2005) three-stage model is used to estimate foreign exchange rate transaction exposures for the sample of 65 UK insurance companies over the period 2004-2013. However, this paper has one important innovation to this method. Instead of the model used in previous papers, the paper uses a model from the actuarial field that was proposed by Blum et al. (2001) for modelling foreign exchange rates with their relevant constituents (inflation and interest rate). Findings The evidence shows that the currency transaction exposure for non-life insurers is greater than that of life insurers. Moreover, the author finds that large insurers exhibit lower frequencies of foreign exchange transaction exposure than small insurers. Originality/value The value of this paper comes from the fact that revealing the nature of cash flow exposures, companies can evaluate the effectiveness of their hedging programmes and focus their hedging efforts according to the nature of their exposures.