Insurance industry regulator IRDAI has allowed insurance companies to hedge risks through equity derivatives to counter market ovolatility.
“Considering the requests from the insurers, the increasing trend of investments in
the equity market by insurers and owing to the associated volatility in the equity prices, a need was felt to permit hedging through equity derivatives as a countermeasure,” the IRDAI said in its guidelines on hedging through equity
derivatives.
The guidelines come at a time the benchmark NSE Nifty 50 Index has declined by around 18 per cent from its September peak coupled with high volatility, highlighting the need for more sophisticated risk management options. Industry sources said that the insurers had earlier sought parity with mutual funds, which can already invest in equity hedging instruments.
According to the guidelines, insurers will be allowed to take short positions in stock futures and index futures to the extent of the existing holding of underlying equities in the respective funds. A short position is created when a trader sells a security first to repurchase it or cover it later at a lower price.
The regulator is also allowing insurance companies to take the position of an option holder (buyer) and buy only put options of stocks and indices against the existing underlying equity holding in the respective funds. A put option gives the holder the right but not the obligation to sell an underlying asset at a certain price within a certain period. If the price of the underlying stock or investment falls, a put option becomes more valuable.
The hedging of risks through equity derivatives will only be available for unit-linked products (ULIPS) that are allowed to invest in equity instruments, life funds, pension, annuity and group funds and investment assets of general or health insurers.
The regulator has also set the exposure limits. The total equity derivative positions in a fund (stock futures, stock options, index futures and index options, all put together) at notional value shall not exceed the market value of underlying equities held within the same fund on any day, the guidelines said. Passive breaches, if any, are to be corrected within 15 days.
The guidelines also stress that insurers must put in place effective risk management policies and processes. “Before taking exposure to equity derivatives, Insurers shall put in place board approved hedging policy (for equity derivatives) which includes hedge accounting framework and detailed methodology for determination of hedge effectiveness, indices to be used for hedging and rationale for selecting such indices,” the guidelines said.
“The hedge through index futures/index options will be deemed to be ‘highly effective’ if at inception and throughout the term of the hedge, the ratio of loss on hedging instrument and gain on cash instrument or vice versa is offset within a range of 80–125 per cent,” the regulator said in the guidelines.
Under the current regulatory framework, IRDAI already allows insurers to deal in rupee interest rate derivatives in the form of forward rate agreements, interest rate swaps, and exchange-traded interest rate futures. Besides fixed-income derivatives, insurers are also permitted to deal in credit default swaps as protection buyers.
Even as government securities dominate the investments of insurance companies, a wider pool of approved investments by IRDAI has been garnering interest in other investment options.
