Irdai Permits Insurers To Invest In Derivatives, Hedge Volatility

The Insurance Regulatory and Development Authority of India (Irdai) recently gave a heads-up to insurers to invest in the derivatives market. The permit has been extended so that insurance companies can reduce the risk factor in their portfolio by hedging the volatility in equity markets and, at the same time, preserve the market value of equity investments.

Following this permit, the insurance regulator has issued guidelines that provide insurers with an opportunity to manage risk and diversify their portfolio.

A Timely Step For Insurance Companies

As insurers increase their investment in the stock market, the regulator has recognised the need to provide a structured approach to risk management. In its guidelines, the Irdai has allowed insurers to use exchange-traded derivates such as stock futures, index futures, stock options, and index options to hedge their current equity holdings.

However, there’s one strict criterion: the insurance regulator wants insurance companies to use this permit for ‘hedging purposes only’, prohibiting any speculative activity or over-the-counter (OTC) derivative exposure.

As per the Irdai release, insurers must comply with stringent exposure and position limits. For instance, the total notional value of equity derivatives in a fund must not exceed the market value of their underlying equity investments held within the same fund.

Moreover, hedging through index futures and index put options is capped at 20 per cent of the unhedged portion of an insurer’s equity holdings.

This permit is even more significant for life insurance companies that offer Unit Linked Insurance Plans (ULIPs) since they already have substantial exposure to equities.

Additionally, Irdai has mandated insurance companies to set up an internal risk management framework that would ensure the responsible use of derivatives. Its key requirements include;

• A board-approved hedging policy that should specify risk management methodologies and hedge effectiveness criteria

• Regular audits and compliance checks by investment risk management auditors

• Defined reporting structures for derivative transactions to senior management and regulatory bodies

• Set up a robust IT infrastructure that should support derivative trading and monitoring.

Moreover, Irdai has further directed insurers to provide clear disclosures in ULIP sales brochures to policyholders, which should;

• Explain intent to trade in derivatives

• Note the associated risk and potential losses. Here, the risks and returns ensuing from the derivative contracts need to be explained by means of a simple quantitative example

• Brief exposure limits set for these investments

• Explain the losses that may be suffered by the policyholders as a consequence of such investments

This permit to insurers is Irdai’s vision to create a more resilient investment landscape for the industry while also protecting policyholders’ interests.