Download - 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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