Hi, I would like to confirm how does using derivatives reduce required capital. It increases counterparty risk hence required capital would increase. It also reduces the risk of mismatching of assets and liabilities so it will reduce interest rate risk capital. Are we saying that interest rate risk capital will reduce substantially hence total required capital will reduce? Let me know if my understanding is correct. Thank you!
It depends on the type of derivative as to what type of risk is being reduced (eg equity put options would impact equity risk exposure, interest rate swaps would impact interest rate exposure). Whatever the principal risk is that is being reduced through the use of the derivative, the impact of the off-setting counterparty default risk will always be less than this (the insurer can't lose more on default than it would expect to have gained).
