Specific instructionsSpecific instructions

Specific instructions

Derivative financial instruments

Derivatives expose insurers to a full range of investment risks, even though in many cases there may be no, or only a small initial outlay. Insurers must set aside capital to cover the investment risk of these transactions particularly where derivatives are used for reasons other than to hedge an underlying physical position.

Where the insurer has derivatives over listed equities, the investment risk capital charge is applied on a portfolio basis and consists of the equity market risk component and equity basis risk component. Any counterparty risk component on the derivatives is still captured on this form. The equity market risk component and the equity basis risk components are to be calculated under GRF 140.1 Investments – Direct Equity Holdings and Risk Charge.

Where an insurer elects to apply the investment capital factors to the underlying assets held under a trust and the trust holds derivatives, then those derivatives should be reported in this form where required.

Derivatives are generally defined as those instruments/contracts, where the value is based on other products, either financial or real, and/or on prices associated with financial products.

Derivative contracts involve:

• Future delivery, receipt or exchange of financial items such as cash or another derivative instrument, or

• Future exchange of real assets for financial items where the contract may be tradeable and has a market value.

The contracts can either be binding on both parties (e.g. as with a currency swap) or subject to the exercise by one party of a right contained in the contract (as with options).

The counterparty in a derivative contract is the party assuming the credit risk. For exchange-traded contracts, credit risk is transferred or assumed by the exchange clearing house. For over the counter (OTC) contracts (e.g. derivative contracts customised for the insurer by a bank), the other party to the contract (seller or buyer) is the counterparty.

Derivative products/contracts are not limited to but include the following:

• Options (including call and put options; exchange-traded and over-the-counter options; interest-rate, bullion, commodity and equity options; warrants);

• Interest rate swaps;

• Cross-currency interest-rate swaps;

• Foreign exchange swaps;

• Foreign exchange forwards;

• Futures (i.e. bank bill, bond, equity); and

• Forward rate agreements.

If the units are held in a related entity of the insurer (i.e. a dedicated investment management entity for the Insurer), the Insurer may apply to APRA to have such entities approved as part of its Extended Licensed Entity (ELE). This is set out in GPS 114. Once approved by APRA, this will allow the insurer to look through the legal structures involved and to consolidate the balance sheet of the related entity with its own for the purposes of determining the investment risk capital charge.

Any associated derivative balances relating to the insurers investment securities/portfolio that is contracted by the related entity must also be recognised by the licensed insurer.

Exclude:

• Derivative margin accounts, which hold deposits lodged with an exchange or clearing house as collateral to cover adverse movements in market prices. These balances are to be reported at item 1 “Deposits or placements with (i.e. money market type deposits / placements)” in GRF 140.0: Investments – Direct Interest Rate Holdings and Risk Charge.

• Repurchase/Resale agreements despite their similarity to a FRAs and/or swaps.

Part 1: Aggregate value of all derivative financial instruments other than exchange traded derivatives by contract type, residual maturity, position and counterparty rating grade

This section of the form requires all derivative contract positions of the reporting insurer (except for derivatives traded on recognised futures and options exchanges which are subject to daily marked-to-market), according to the contract type, into residual maturity bands, by long or short position and by counterparty rating grade. Insurers should choose the applicable derivative contracts from the drop-down menu within the form:

1. Contract type

From the drop-down menu, choose the contract type for all derivative financial instruments (other than exchange traded derivatives) held by the insurer:

• Interest Rate;

• FX and Gold;

• Equity;

• Precious metal (excl Gold)[5]; and

• Other.

2. Residual Maturity

Residual maturity refers to the time remaining from the reporting date to the maturity date of the derivative financial contract.

From the drop-down menu, choose the appropriate residual maturity of the corresponding derivative financial instrument:

• Less than 1 year
• 1 year to less than 5 years
• 5 years or more

3. Position

For each derivative exposure reported, from the drop-down menu, choose whether the instrument is a long or a short position.

• Long position
• Short position

4. Counterparty rating grade

For each derivative exposure reported, from the drop-down menu, choose the appropriate counterparty grade of the derivative contract. The counterparty grades align with the grades specified in GPS 114.

5. Principal amount

Note: Always record this value as positive, even for short positions in derivative financial instruments.

Principal amount for the purpose of this form refers to the face value or notional principal amount of the derivative financial contract.

Record the aggregate face value or notional principal amount (always positive) of the derivative exposure/position separated into net long or net short positions, for each of the items listed. Amount is to be rounded to thousands of Australian dollars. The notional principal amount of a contract is the reference amount used to calculate payment streams between counterparties to a contract.

6. Mark to Market Value

Record the aggregate mark to market value of the derivative exposure/position separated into net long or net short positions, for each of the items listed. Amount is to be rounded to thousands of Australian dollars.

Mark to market value (or replacement cost) represents the difference between:

• the price of entering into a new contract to replace the original contract; and
• the price of the original contract excluding transaction costs.

7. Potential exposure add-on Factors %

The potential exposure add-on factors as specified in GPS 114 are:

8. Asset equivalent

Do not enter a value in this column. The form automatically calculates the asset equivalent value of the derivative exposure. This is calculated based on the Prescribed Method set out in GPS 114, and is the sum of the:

1. Positive mark-to-market value (or replacement cost) of the derivative position (refer below); plus
2. A potential exposure add-on.

Current mark-to-market value of the derivative position

The current mark-to-market value of a derivative is only applicable where the position has a positive replacement value to the insurer. If the current mark-to-market value of the position is negative or zero, the value is not included in the calculation, as the calculation of the asset equivalent amount is trying to capture the credit risk value of the derivative position to the insurer.

A potential exposure add-on

The potential exposure add-on for a derivative position is determined by multiplying the notional principal amount of the derivative contract by the appropriate credit conversion factors outlined in the table above. This component of the calculation is required for all derivatives regardless of whether the derivative contract has a positive, zero or negative mark-to-market value.

9. Investment Capital Factor %

The investment capital factors are specified in GPS 114. These are based on the rating of the counterparty to the derivative contract.

10. Investment Risk Capital Charge

Do not enter a value in this column. This column automatically calculates the appropriate investment capital charge based on the information entered. The capital charge is calculated by multiplying the asset equivalent value by the investment capital factor applicable for each counterparty grade.

Risk Charge for:

• Interest Rate Contracts
• Foreign Exchange and Gold Contracts
• Equity Contracts
• Precious Metal Contracts (excluding Gold)
• Other Market-Related Contracts

Do not enter a value in these fields as they are automatically calculated. This is the total capital charge calculated for each contract type.

Total Derivatives Activity Risk Charge

Do not enter a value in this field as this is automatically calculated. This is the total capital charge calculated for all contract types, based on the aggregate value of all derivative financial instruments other than exchange traded derivatives.

Part 2: Total Contracts