BackIrda allows insurers to deal in interest rate derivatives
Move may potentially boost the turnover of exchange-traded IRFs, which has been a non-starter due to low liquidity
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Mumbai: The Insurance Regulatory and Development Authority (Irda) on Monday allowed insurers to invest in interest rate derivatives for hedging against interest rate risks in their transactions.
The insurance regulator said insurers are allowed to deal in rupee interest rate derivatives such as forward rate agreements (FRA), interest rate swaps (IRS) and exchange-traded interest rate futures (IRF).
According to the norms, insurers will be allowed to use interest rate derivatives to hedge for transactions that include reinvestment of maturity proceeds of existing fixed income investments; investment of interest income receivable; and expected policy premium income receivable on the insurance contracts which are already underwritten in life and pension and annuity business.
However, an insurer’s dealings in interest rate derivatives cannot exceed an outstanding notional principal amount equivalent to 100% of the book value of its fixed income investments under the policyholders’ fund and the shareholders’ funds taken together.
While dealing in FRAs and IRS, insurers have to ensure that their counter parties are either commercial banks or primary dealers only.
All insurers, dealing in interest rate derivatives have also been asked to disclose the details of their hedging strategy, accounting policy and nature of outstanding interest rate derivatives in their financial statements. They will also be required to disclose the quantum of losses which would be incurred if counter-parties fail to fulfil their obligation under the outstanding interest rate derivative contracts.
“While dealing with such potentially complex products, the board and the senior management of insurer should understand the nature of the risk undertaken, complexities involved, stress levels, etc.," Irda said.
However, IRS bearing option features will be prohibited for insurers.
The move may potentially boost the turnover of exchange-traded IRFs, which has been a non-starter due to low liquidity. On NSE, the total monthly turnover of IRFs increased from ₹ 8,819.75 crore in January to ₹ 10,222.78 crore in June so far. On BSE, the monthly turnover of IRFs fell from ₹ 1,085.39 crore in January to ₹ 645.73 crore in June.
“The guidelines on dealing in interest rate derivatives are a welcome step since it would enable life insurers to hedge the interest rate risks on the future premiums to be collected by them," said Sandeep Batra, executive director, ICICI Prudential Life Insurance Co. Ltd. “Earlier, the risk was borne by insurers. We believe this could also popularize regular premium traditional products with in-built guarantees."
An IRF is an agreement to buy or sell an underlying debt security at a fixed price on a fixed day in the future, and the prices of these derivatives mirror the rise and fall in the yield of the underlying government bonds. Unlike overnight interest rate swaps, IRFs have to be traded on exchanges rather than over the counter.
IRFs made their debut on the National Stock Exchange (NSE) on 31 August 2009, six years after an earlier edition failed, as part of new efforts to allow participants to buy protection against and bet on interest rates changes. Later, BSE too started offering trading in IRFs.
However, soon after its debut trading, volumes slumped on worries about the limited variety of players in the market and fears that the nature of contracts were loaded in favour of sellers.
Another critical issue has been the absence of participants with contrarian views on interest rate movements, which is where insurers can play a major role as their investments are mostly long term in nature.
Typically, all banks tend to go short on bond trades, assuming that the interest rates will rise in the future. This created a shortage of enough “long only" players, or those who buy bonds. If insurance companies start participating, there will be players on the long side, which may improve the liquidity.
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