Irdai’s Move toward Equity Derivatives

Context:

At Irdai’s direction, insurers could hedge their equity exposure on derivatives, providing a tool for better market volatility management and protection of policyholder returns. This step seems to enhance risk management, but experts suggest it is not going to drastically affect the insurers’ particular investment strategy.

Current Regulatory Setup

• Prior to this decision, Irdai permitted the insurers to hedge:
  • Interest rate derivatives in rupees, consisting of:
    • Forward Rate Agreements (FRAs)
    • Interest Rate Swaps
    • Exchange Traded Interest Rate Futures (IRFs)
    • Credit Default Swaps (CDS) for protection to buyers.

Due to the increasing investment in equities by insurers and market volatility, Irdai realized the need to allow the hedging of equity derivatives.

Impact on Life Insurers

• Life insurers generally assign 30-35% of their portfolio to equities, with the remaining portion in fixed income instruments. This is probably higher than general insurers and hence gives them more exposure to equity market risks.

Equity Exposure in Policy Types

• Unit linked policies could be fully equity based or a mix of equity and debt.
• Traditional Fund has fixed equity allocation or flexible equity allocation.
• The average equity to debt ratio is 35:65, with substantial variation across insurers.
• Equity market experts believe Irdai’s decisions will provide liquidity in single stock options.

Guidelines & Next Steps

• Key Features of Irdai’s New Guidelines
  • Permitted instruments for hedging:
    • Stock and index futures
    • Stock and index options
• Only for hedging
  • The equity derivatives can be used for risk management purposes. No speculation.