Derivatives Usage by Insurer and Role of Deri ati es inand Role of Derivatives in

Recent Economic MeltdownRecent Economic Meltdown

Prabhat Kumar MaitiPrabhat Kumar MaitiDD(Actl)/ IRDA

11th GCA, Mumbai 1

Possible uses of derivatives by Insurance ycompanies

Efficient portfolio management.H d i ifi li biliti Hedging specific liabilities.

Enhancing returns or speculationsg p Solvency management.

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Efficient Portfolio Managementg

Reduction of investment riskT ti l t ll ti Tactical asset allocation.

Tax Management.g

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Hedging specific Liabilitiesg g p

Liabilities for structured funds.O ti b dd d i t diti l d t Options embedded in traditional products.

With profit guaranteesp g

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Enhancing returnsg

Creating synthetic assets.i d li k d t b d fi de.g. index linked corporate bond = fixed

interest corporate bond + interest rate swaps. Exploiting investment opportunities.

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Solvency managementy g

Reducing risk of falling equity value using equity put option.

Protect solvency against the event of adverse movements in interest ratemovements in interest rate.

Shifting effective asset allocation from bond to eq itto equity.

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Evolution of derivative in Indian Market

D i ti t di l d ith th iti l Derivative trading was cleared with the securities laws amendment bill on 1998.

But trading was started with the introduction of BSE30(Sensex)index future and S & P CNX Nifty index future in the year 2000.

In January 2004, the IRDA allowed Insurance companies to deal In January 2004, the IRDA allowed Insurance companies to deal in financial derivatives to a limited extent.

In January 2004, RBI, allowed FIIs to trade in equity derivative.I th 2006 ith th d t f RBI t OTC d i ti In the year 2006 with the amendment of RBI act OTC derivative transaction 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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Exchange Traded Derivative transaction gupto December’ 2007

Total No. of Derivative Transaction in BSE & NSE Notional Turnover of Derivative transaction in BSE &Total No. of Derivative Transaction in BSE & NSE

250030003500

Notional Turnover of Derivative transaction in BSE & NSE

12001400

1000150020002500

In L

akhs BSE

NSE

400600800

10001200

'000

Cro

res

BSE

NSE

0500

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Dec-06

Jun-07

Dec-07

0200

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Jun-06

Dec-06

Jun-07

Dec-07

In '

Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De

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As per IRDA Guidelinep

Derivative instrument allowed

F d t t

Permitted Purpose of Dealing in Derivative

Forward rate agreement (FRAs). Hedging interest rate risk of

investment in fixed income Interest rate Swaps (IRS)

investment in fixed income securities.

Exchange Traded Interest Rate Futures

Hedging for forecasted transaction

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Shortcomings of Existing Guidelineg g

Historicall fi ed income sec rities are less olatile Historically fixed income securities are less volatile & with less default risk.

Short term MMIs are very secured and no hedging is Short term MMIs are very secured and no hedging is required.

Exchange traded fixed income derivatives usually h t l th l di diffi lthave term less than one year leading difficulty on hedging long term security return.

Cost of hedging may outweigh the benefit from Cost of hedging may outweigh the benefit from hedging.

Current guideline is silent about the insurers liability, f h d i h ld b i h ha perfect hedging should be with respect to the

liability.

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Derivative Segment (SEBI Handbook 2008 page 43)

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Regulator may seek information on:g y

Th f hi h d i ti t b d The purpose for which derivatives to be used. Procedures for approval of counterparties

and brokers. The limits to credit, market and other risk., Exposure limit. Procedure for monitoring the liquidity risk Procedure for monitoring the liquidity risk. The professional qualification of those

entrusted with derivative activitiesentrusted with derivative activities. The valuation methodology.

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Properties of Derivatives that may be p yallowed to Insurance companies:

Th t ti l h ld b li bl The potential exposure should be reliably measured.

Closing out of the derivative should not be difficult.

The derivative should be readily marketable. Independent verification of pricing should be Independent verification of pricing should be

possible. The counterparty should be suitably The counterparty should be suitably

creditworthy.

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Deposit Insurance Corporation Act of p pCanada

Eli ibl fi i l t tEligible financial contract: A derivative agreement that trade on a futures or options

exchange or other regulated market. An agreement to

- borrow or lend securities or commodities, ttl iti f t ti d i ti- settle securities, futures, options or derivative

- act as a depository for security A repurchase, buy-sellback agreement wrt securities or p , y g

commodities. A margin loan in securities account or future accounts.

Any combination of the above four Any combination of the above four.

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Insurance & Superannuation commission ofpAustralia

Some restriction on following types of instruments Highly leverages derivatives. Uncovered derivatives. Derivatives where the potential of losses is considerably

hi h th th i iti l i t thigher than the initial investment. Derivatives where the potential exposure is not

measurablemeasurable. Derivatives where closing out the position is difficult.

D i ti h th d l i t i t d i ibl Derivatives where the underlying asset is not admissible for solvency purpose.

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Life insurance products with guaranteed p gbenefit

C it l t Capital guarantee- Gross premium return guarantee

N t i t t- Net premium 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 Guaranteed

M t it i l l t d t th i NAV d dMaturity is calculated at the maximum NAV recorded 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 the triggering role in the recent turbulent condition in the Global financial market.

The CDS has been called as “the most important instrument in finance” by formerimportant instrument in finance by former Federal Reserve Chairman and a financial “weapon of mass destruction” by Warrenweapon of mass destruction by Warren Buffet.

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How CDS functions

Reference entity is the Borrower.

Diagram of a Typical CDS:

Default protection Buyer i th l d

Default protection

Buyer

is the lender. Default

t ti llReference

EntityPremiumPayment

InDefaultprotection seller

is the issuer of CDS

y

Default protection

Default

CDS. protectionSeller

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CDS pricing:p g

PV of CDS = Premium * Discount Factor PV of Credit Protection = Claim received*DP*DFPremium calculated by solving the equation:PV of CDS PV of Credit Protection = 0PV of CDS - PV of Credit Protection = 0Cash Flow:

Premium Inflow

Claim received from counterparty

Premium Inflow

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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 lloan.

CDS may be purchased by protection buyer that th d l i b d f hi h t ti iown the underlying bond for which protection is

provided.A ti l i b id b th An one time or regular premium can be paid by the CDS purchaser to the issuer of CDS, which depend on the outstanding loan or amount of loan which ison the outstanding loan or amount of loan which is exposed to the risk of default.

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Issues with CDS

I th l b l k t CDS OTC t t In the global market, CDS are OTC contract and completely unregulated.

The formula for deciding the premium of CDS contains the default probability (P) and the expected recovery rate (R) of the reference entity (borrower).

P & R again determined by the yield of the loan (bond).

The probability of the default of the counterparty is ignored.

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p y g

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 exposure by global Insurers:p y g

Long position on CDS

50 000

Short position in CDS

30,00040,00050,000

mill

ion

D30,00040,00050,000

mill

ion

lar

010,00020,000

In '0

00 m

US

010,00020,000

In '0

00

dol

0

Dec04

Jun05

Dec05

Jun06

Dec06

Jun07

Dec07

Jun08

Dec04

Jun05

Dec05

Jun06

Dec06

Jun07

Dec07

Jun08

All counterparties InsurersAll counterparties Insurers

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Conclusion:

I l E h t d d d i ti In general Exchange traded derivatives are popular tool for global insurance fund managers.

Indian fund managers should also be given higher level of flexibility removing too much restriction on derivative usage.

For increase in popularity of Guaranteed benefit product.

For managing any future innovative products e.g. Variable Annuity.

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g y

Th k YThank You

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