3.5 Currency risk

3.5.1 Definition

146. Currency risk is the risk of adverse change in the value of capital resources due to unexpected changes in the level or volatility of currency exchange rates. This risk may arise from the assets and/or liabilities, taking into account that changes in the value of some items on the balance sheet may be partially or totally offset by changes in value of other items on the balance sheet.

3.5.2 ICS methodology

147. The ICS Currency risk charge is the higher of the aggregated losses incurred under two scenarios stressing the exchange rates between the IAIG’s consolidated group level reporting currency and those currencies in which the IAIG holds assets or liabilities. The two stress scenarios are:

• a. Scenario 1: All currencies in which the IAIG has a net long position decrease in value against the reporting currency, while all currencies in which the IAIG has a net short position remain unchanged; and
• b. Scenario 2: All currencies in which the IAIG has a net short position increase in value against the reporting currency, while all currencies in which the IAIG has a net long position remain unchanged.

148. The stress applies on the net open position (Assets – Liabilities) for each currency after allowing an exemption for investments in foreign subsidiaries up to 10% of the net insurance liabilities in a currency from the net open (long) position in that currency.
149. A diversification allowance (i.e. pairwise correlation of 50%) is assumed between the stressed results by currency.
150. The currency level stresses are determined using granular pairwise bidirectional relative currency stresses.

3.5.3 Calibration

151. The Currency risk section of the 2016 ICS public consultation included the proposed methodology, along with stresses, single correlation factors for all currencies in a time of stress, treatment of investments in foreign subsidiaries, treatment of currency pegs and treatment of currency exposures with a maturity of less than one year.
152. The 10% exemption for investments in foreign subsidiaries has been selected as a proxy of the average capital requirement across jurisdictions.
153. Pair-wise volatilities have been calculated using weekly exchange rate data from 1 January 1999 to 31 December 2018 for each pair of currencies for 35 predefined currencies.
154. Weekly volatilities have then been converted to a 99.5% VaR over a 1-year time horizon, using a square root of time derived gross up factor and assuming a normal distribution. The results have been rounded to the nearest 5% value, with an absolute 2% floor.