Draft Guidelines on Fixed Income derivatives – IRDA

All Stakeholders are requested to review the attached Draft Guidelines and forward their view/comments to the following address  within 30 days. 

Joint Director (Investments), IRDA, Parishram Bhavan, 5th Floor, Basheerbagh, Hyderabad – 500 004.

Comments may also be forward by email at maheshagarwal@irda.gov.in and ramanaraoa@irda.gov.in

Sd/-R. K. Nair

Member (F & I) 

Draft guidelines on Fixed Income Derivatives 

18th June, 2013 

IRDA permitted insurers to deal in Financial Derivatives only to the extent permitted and in accordance with the guidelines issued by the Authority vide Regulation 11 which got inserted in 2004inteheIRDA (Investment) Regulations, 2000. Accordingly the  Authority issued detaile3d Guidelines on Fixed Income Derivatives vide the INV/GLN/008/2004-05. The said guidelines inter-alia permits the insurers to enter Forward Rate Agreements (FRAs). Interest Rate Swaps (IRS), Exchange Traded Interest Rate Futures with a maximum tenure of 1 year to hedge the Interest Rate risk on Investments and the forecasted transactions.

Need is fell by the Authority to review the above guidelines in view of the change in Investment environment, product structures, change in guidelines by the sectorial Regulator RBI etc. The Authority is also in receipt of representations from some of the Insurers to revisit the earlier guidelines and to permit the insurers to hedge their interest rate risk with longer term Financial Derivatives.

After careful examinations of the above, the Authority proposed to withdraw the earlier guidelines and to issue the fresh guidelines as under.

A) Insurers are allowed to deal as user with following types of Rupees Interest Rate Derivatives to the extent permitted, and in accordance with these guidelines.

1. Forward Rate Agreements (FRAs)
2. Interest Rate Swaps(IRS), and
3. Exchange  Traded Interest Rate Futures 

Participants can undertake different types of plain vanilla FRAs/IRS. IRS having explicit/implicit option features such as caps/floors/collars are not permitted. It is to be noted that FRAs nadirs are OTC contracts.

B) Permission to Insurers in the Rupee Interest Rate Derivatives are governed by the guidelines issued by the RBI vide circular No.RBI/206-2007/333 dated 20 April 2007, RBI/2011-12/136 dated 02 August, 2011, RBI/2011-12/243 dated 02 November 2011 and as amended by RBI from time to time.  

C) Permitted purpose of Dealing in Fixed Income Derivatives : 

i. Hedging interest rate risk of investment in fixed income securities:

This would cover fixed income derivatives positions that are designed to offset the potential losses from existing fixed income investments of the Participant

ii. Hedging for forecasted transactions: 

This would cover positions in fixed income derivative contracts that are designed to mitigate projected loss due to probable change in interest rates on :

• Investment of policy premium income receivable for 10 years.
• Reinvestment of maturity proceeds of existing fixed income investment with outstanding term shorter than 10 year.
• Investment of interest income receivable within a period of 10 year.
• On homogenous group of assets and liabilities, provided the assets and liabilities are individually permitted to be hedged for a term of 10 years.

D) Regulatory Exposure and Prudential Limits 

i) The counter parties necessarily have to be Commercial Banks and Primary dealers (PDS) as permitted by RBI for FRAs and IRS.
ii) Insurers dealing in FRAs and IRS have to arrive at the credit equivalent amount for the purposes of reckoning exposure to a counter-party. For this purpose, Participants shall apply the conversion factors to national principal amounts as flows :

a. National principal amount of each FRA/IRS is to be multiplied by the conversion factor given below :

Original Maturity                           Conversion Factor

Less than one year                      0.5 per cent

One year and less than two year   1.0 percent 

For each additional year                2.0 percent 

b. The adjusted value thus obtained shall be treated as the credit equivalent amount of the FRA/IRS for reckoning counter party credit exposure for the purposes of the Insurance Regulatory and Development Authority (Investment) Regulations, 2000.

iii) Exposure limits pertaining to single issuer, Group and Industry will be applicable for the exposure through FRA and IRS contracts. No contracts shall be entered with promoter group entities either directly or indirectly. Further, exposure to derivative instruments with underling Infrastructure instrument shall be treated as exposure to Infrastructure sector. 

iv) A Participant’s dealing in fixed income derivatives under these guidelines shall in aggregate not exceed an outstanding notional principal amount equivalent to 100% of the book value of the fixed income investments of the Participant under the Policyholders Fund and the Shareholders Fund taken together.

E) Insurers are advised to ensure documentation requirements complete in all aspects as per guidelines of RBI such as documentation prescribed by ISDA (International Swaps and Derivative Association). Further, to settle the mark to market profits/losses and maintenance of collateral, suitable CSA (Credit Support Annex) agreements shall be mandatory to mitigate the counterparty risk CSA is an agreement between counterparties on the types of collateral and posting mechanism. The governing law should necessarily be India. Suitable clauses should be incorporated to suit the regulatory framework applicable to Insurers. Insurers shall necessarily have power to terminate the contracts as and when desired. 

F) Accounting of Fixed Income Derivatives shall be as per Accounting Standard – 30 applicable for Hedge accounting as mandated by ICAI and amended from time to time. The presentation in the financial statements and disclosures are governed by AS 31 and 32 issued by ICAI. In specific, the Insurer have to make the following disclosures in the Financial statements :

Description of Participant’s financial risk management objective and policies in particular its policy for hedging forecasted transactions.

1. Hedge Accounting policy 
2. The aggregate notional principal of outstanding fixed income derivative contracts.
3. Nature and terms of outstanding fixed income derivative contracts.
4. Quantification of the losses which would be incurred if counter-parties failed to fulfill their obligation under the outstanding fixed income derivative contracts. 
5. The fair value of the total outstanding fixed income derivative instruments, and 
6. Details of ineffective hedge transactions and management reasons therefor. 

G) Internal Risk Management policy and processes, Exposure and Prudential limits 

Each participant should, before commencement of dealing in fixed income derivatives, frame detailed risk management policy. The policy shall cover 

1. Insurers overall appetite for taking risk and ensure that it is consistent with its strategic objectives, capital strength etc.
2. define the approved derivatives products and authorized derivatives activities
3. provide for sufficient staff resources and other resources to enable to approved derivatives activities to be conducted in a prudent manner 
4. ensure appropriate structure and staffing for the key risk control functions
5. establish management responsibilities
6. iidentify the various types of risk raced by the Insurer and establish a clear and comprehensive set of limits to control these
7. establish risk measurement methodologies which are consistent with the nature and scale of the derivatives activities 
8. require stress testing of risk positions
9. detail the type and frequency of reports which are to be made to the board (or committees of the board)
10. applicable stop loss and VAR limits 
11. circumstances for termination and closure of the contract

The implementation of the policy is the responsibility of the Investment Management committee with an oversight by the Board of Directors.

H) Suitability and appropriateness policy :

The Board shall ensure that the rupee Interest Rate Derivatives are suitable for the portfolio handled by the Insurer and the liabilities undertaken by the Insurer. The Board shall supervise whether suitability and appropriateness   was evaluated by the market maker I terms of clause 8.3 of guidelines issued by RBI

I) Corporate Governance :

While dealing with such potentially complex products, the Board and the senior management should understand the nature of the risk undertaken complexities involved, stress levels etc At periodical intervals (at least once in an year) the Board of Director shall review the contracts undertaken and satisfy themselves that adequate risk measurement and management policy and procedures for measurement and management of interest rate risk with fixed income derivative contracts permitted in these guidelines, have been established and are functional. 

J) Reporting and Audit 

Quarterly report shall be submitted to the Authority as per Annexure A, if the Insurer undertakes any Rupee Interest Derivatives. Further, the concurrent auditor shall ensure the compliance of the above guidelines and have to comment in his quarterly report submitted to the Authority.