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.

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 110 Capital Adequacy. 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 in the Investments form under the appropriate line item within “Call Deposits”.

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

Aggregate value of all derivative financial instruments (other than exchange traded) with residual maturity of:

1. 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), to be classified into the residual maturity bands specified:

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

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

2. Derivative exposures/positions applicable for each of the above residual maturity bands is then required to be sub classified into those exposures/positions that are either long or short positions.

3. Within the long and short position sub classification, derivative exposures are then required to be further sub classified into the appropriate investment/counterparty grade of the derivative contract. The counterparty grades align with the grades specified in GPS 110 Capital Adequacy.