derivative usage in insurance

7/31/2019 Derivative Usage in Insurance

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Derivatives Usage by Insurer

v v

Prabhat Kumar Maiti

DD(Actl)/ IRDA

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Possible uses of derivatives b Insurance

companies

Efficient portfolio management.

e g ng spec c a es. Enhancing returns or speculations

Solvency management.

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Efficient Portfolio Mana ement

Reduction of investment risk

ac ca asse a oca on. Tax Management.

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Hed in s ecific Liabilities

Liabilities for structured funds.

p ons em e e n ra ona pro uc s. With profit guarantees

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Enhancin returns

Creating synthetic assets.

e.g. n ex n e corpora e on = xeinterest corporate bond + interest rate swaps.

Exploiting investment opportunities.

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Solvenc mana ement

Reducing risk of falling equity value using

equity put option. Protect solvency against the event of adverse

.

Shifting effective asset allocation from bond

o equ y.

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Evolution of derivative in Indian Market

er va ve ra ng was c eare w e secur es awsamendment bill on 1998.

But trading was started with the introduction ofBSE30(Sensex)index future and S & P CNX Nifty index future inthe year 2000.

in financial derivatives to a limited extent. In January 2004, RBI, allowed FIIs to trade in equity derivative.

n e year w e amen men o ac er va vetransaction is allowed provided one of the parties is either RBI or

any entity regulated under RBI act, banking regulation or FEMA.

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Exchan e Traded Derivative transaction

upto December 2007

3000

3500

NSE

1400

1000

1500

2000

In

Lakh

s

BSE

NSE

400

600

8001000

'000

C

ror

es

BSE

NSE

0

500

un-0

ec-02

un-03

ec-03

un-04

ec-04

un-05

ec-05

un-06

ec-06

un-07

ec-07

0

200

un-02

ec-02

un-03

ec-03

un-04

ec-04

un-05

ec-05

un-06

ec-06

un-07

ec-07

In

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As er IRDA Guideline

Derivative instrument allowed Permitted Purpose of

Dealing in Derivative

orwar ra e agreemen

(FRAs). Hedging interest rate risk of

Interest rate Swaps (IRS)

securities.

Exchange Traded Interest

Rate Futures

Hedging for forecasted

transaction

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Shortcomin s of Existin Guideline

s or ca y xe ncome secur es are ess vo a e& with less default risk.

required.

Exchange traded fixed income derivatives usually

ave erm ess an one year ea ng cu y onhedging long term security return.

hedging.

Current guideline is silent about the insurers liability,a per ect hedging should be with respect to theliability.

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Derivative Segment (SEBI Handbook 2008 page 43)

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Re ulator ma seek information on:

e purpose or w c er va ves o e use .

Procedures for approval of counterpartiesand brokers.

The limits to credit market and other risk.

Exposure limit.

.

The professional qualification of those.

The valuation methodology.

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Pro erties of Derivatives that ma be

allowed to Insurance companies: e po en a exposure s ou e re a y

measured. Closing out of the derivative should not be

difficult.

The derivative should be readily marketable.

possible.

creditworthy.

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Deposit Insurance Corporation Act of

Canadag e nanc a con rac :

A derivative agreement that trade on a futures or options

exchange or other regulated market. An agreement to

- borrow or lend securities or commodities,

- se e secur es, u ures, op ons or er va ve

- act as a depository for security

A re urchase bu -sellback a reement wrt securities orcommodities.

A margin loan in securities account or future accounts. .

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Insurance & Su erannuation commission of

AustraliaSome restriction on following types of instruments

Highly leverages derivatives. Uncovered derivatives.

Derivatives where the potential of losses is considerably

g er an e n a nves men . Derivatives where the potential exposure is not

.

Derivatives where closing out the position is difficult. er va ves w ere e un er y ng asse s no a m ss e

for solvency purpose.

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Life insurance roducts with uaranteed

benefit ap a guaran ee

- Gross premium return guarantee- et prem um return guarantee

Guarantee in rate of return on

- Gross premium- net premium

(either in maturity or surrender or both)

CPPI type of product where the Guaranteeda ur y s ca cu a e a e max mum recor e

throughout the term.

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Role of Derivative in the recent Market

Meltdown. The OTC Credit derivatives mainly the CDS

(credit default swap) are claimed to play thetriggering role in the recent turbulent

condition in the Global financial market.

The CDS has been called as the most

Federal Reserve Chairman and a financial

Buffet.

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How CDS functions

Reference entity

is the Borrower.

Diagram of a Typical CDS:

Default

protection Buyer

Defaultprotection

Buyer

s e en er. Default Reference

Entit

PremiumPayment

In

pro ec on se er

is the issuer of Default. Seller

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CDS ricin :

PV of CDS = Premium * Discount Factor

PV of Credit Protection = Claim received*DP*DFPremium calculated by solving the equation:

-

Cash Flow:

Claim received from counterparty

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CDS: Whether Insurance or derivative

CDS is like an insurance policy used by the debt

owners to hedge or insure against the default on a

oan.

CDS may be purchased by protection buyer that

own e un er y ng on or w c pro ec on sprovided.

n one me or regu ar prem um can e pa y e

CDS purchaser to the issuer of CDS, which depend

exposed to the risk of default.

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Issues with CDS

n e g o a mar e , are con rac

and completely unregulated. The formula for deciding the premium of CDS

contains the default probability (P) and the

expected recovery rate (R) of the referenceentity (borrower).

P & R again determined by the yield of the

loan (bond). The probability of the default of the

counter art is i nored.

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Growth of CDS market.

Till 6/2008 the total market underlying the credit

derivative crossed USD 62 trillion.

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CDS used Global Insurers BIS data

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CDS ex osure b lobal Insurers:

Long position on CDSShort position in CDS

30,000

40,000

50,000

illion

D30,000

40,000

,

m

illion

lar

0

10,00020,000

In'

00

0

U

S

0

10,000

20,000

In'

00

0

d

ol

Dec

04

Jun

05

Dec

05

Jun

06

Dec

06

Jun

07

Dec

07

Jun

08

Dec

04

Jun

05

Dec

05

Jun

06

Dec

06

Jun

07

Dec

07

Jun

08

All counterparties InsurersAll counterparties Insurers

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Conclusion:

n genera xc ange ra e er va ves are

popular tool for global insurance fundmanagers.

Indian fund managers should also be given

higher level of flexibility removing too muchrestriction on derivative usage.

For increase in popularity of Guaranteed

benefit product. For managing any future innovative products

e. . Variable Annuit .

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an ou

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derivative usage in insurance

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