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