Division (ii) Derivatives - Insurance Act 1973 - Determination of Prudential Standards - GPS 110 - Capital Adequacy for General Insurers; GPS 120 - Assets in Australia for General Insurers; GPS 210 - Liability Valuation for General Insurers; GPS 220 - Risk Management for General Insurers; GSP 230 - Reinsurance Arrangements for General Insurers; GPS 410 - Transfer and Amalgamation of Insurance Business for General Insurers and Transitional Prudential Standard GPS 900- Early Approvals of Auditors and Actuaries (07/02/2002) - (ii) Derivatives

(ii) Derivatives(ii) Derivatives

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Turn the raw legal text into a practical explanation grounded in Insurance Act 1973 - Determination of Prudential Standards - GPS 110 - Capital Adequacy for General Insurers; GPS 120 - Assets in Australia for General Insurers; GPS 210 - Liability Valuation for General Insurers; GPS 220 - Risk Management for General Insurers; GSP 230 - Reinsurance Arrangements for General Insurers; GPS 410 - Transfer and Amalgamation of Insurance Business for General Insurers and Transitional Prudential Standard GPS 900- Early Approvals of Auditors and Actuaries (07/02/2002).

(ii) Derivatives

Derivatives include forwards, futures, swaps, options and other similar contracts. Derivatives expose insurers to the full range of investment risks, even though in many cases there may be no, or only a very small, initial outlay. Insurers must set aside capital to cover the Investment Risk of these transactions, particularly in instances where the derivatives are used for reasons other than to hedge an underlying physical position. Under the Prescribed Method, insurers are required to hold capital against derivatives using the method described below.
The requirements set out below do not apply to:

(a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and

(b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.

The capital charge for each derivative contract is based on its ‘asset equivalent value’. The asset equivalent value is the sum of the current mark-to-market exposure of the derivative (where positive) and a potential exposure add-on.
The potential exposure add-on is determined by multiplying the notional principal amount of the derivative contract (regardless of whether the contract has a zero, positive or negative mark-to-market value) by the relevant credit conversion factor specified in the table below according to the nature and residual maturity of the instrument.[21]

Residual Maturity	Interest Rate Contracts	Foreign Exchange & Gold Contracts	Equity Contracts	Precious Metal Contracts (except Gold)	Other Contracts
Less than 1 year	Nil	1.0%	6.0%	7.0%	10.0%
1 year to less than 5 years	0.5%	5.0%	8.0%	7.0%	12.0%
5 years or more	1.5%	7.5%	10.0%	8.0%	15.0%

The asset equivalent value of each derivative must then be multiplied by the Investment Capital Factor applicable to a debt obligation of the counterparty to the derivative contract to determine the Investment Risk Capital Charge.

Asset	Investment Capital Factor
CashDebt Obligations of:the Commonwealth Government;an Australian State or Territory government; orthe national government of a foreign country where: the security has a Grade 1 counterparty rating; or, if not rated, the long-term, foreign currency counterparty rating of that country is Grade 1.GST receivables (input tax credits)	0.5%
Any debt obligation that matures or is redeemable in less than one year with a rating of Grade 1 or 2Cash management trusts with a rating of Grade 1 or 2	1%
Any other debt obligation (that matures or is redeemable in one year or more) with a rating of Grade 1 or 2Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 1 or 2	2%
Unpaid premiums due less than 6 months previouslyUnclosed businessAny other debt obligation with a rating of Grade 3Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 3	4%
Any other debt obligations with a counterparty rating of Grade 4Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 4	6%
Any other debt obligations with a counterparty rating of Grade 5Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 5Listed equity instruments (including subordinated debt)Units in listed trustsUnpaid premiums due more than 6 months previously	8%
Direct holdings of real estateUnlisted equity instruments (including subordinated debt)Units in unlisted trusts (excluding Cash Management Trusts listed above)Other assets not specified elsewhere in this table	10%
Loans to directors of the insurer or directors of related entities[22] (or a director’s spouse)Unsecured loans to employees exceeding $1,000Assets under a fixed or floating charge (refer paragraphs 14‑15)	100%
Goodwill (including any intangible components of investments in subsidiaries)Other intangible assetsFuture income tax benefits(Assets in this category are zero weighted because they are deducted from Tier 1 capital when calculating an insurer’s capital base – refer GGN 110.1)	0%

Asset

Investment Capital Factor

CashDebt Obligations of:the Commonwealth Government;an Australian State or Territory government; orthe national government of a foreign country where: the security has a Grade 1 counterparty rating; or, if not rated, the long-term, foreign currency counterparty rating of that country is Grade 1.GST receivables (input tax credits)

0.5%

Any debt obligation that matures or is redeemable in less than one year with a rating of Grade 1 or 2Cash management trusts with a rating of Grade 1 or 2

Any other debt obligation (that matures or is redeemable in one year or more) with a rating of Grade 1 or 2Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 1 or 2

Unpaid premiums due less than 6 months previouslyUnclosed businessAny other debt obligation with a rating of Grade 3Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 3

Any other debt obligations with a counterparty rating of Grade 4Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 4

Any other debt obligations with a counterparty rating of Grade 5Reinsurance recoveries, deferred reinsurance expenses and other reinsurance assets due from reinsurers with a counterparty rating of Grade 5Listed equity instruments (including subordinated debt)Units in listed trustsUnpaid premiums due more than 6 months previously

Direct holdings of real estateUnlisted equity instruments (including subordinated debt)Units in unlisted trusts (excluding Cash Management Trusts listed above)Other assets not specified elsewhere in this table

10%

Loans to directors of the insurer or directors of related entities[22] (or a director’s spouse)Unsecured loans to employees exceeding $1,000Assets under a fixed or floating charge (refer paragraphs 14‑15)

100%

Goodwill (including any intangible components of investments in subsidiaries)Other intangible assetsFuture income tax benefits(Assets in this category are zero weighted because they are deducted from Tier 1 capital when calculating an insurer’s capital base – refer GGN 110.1)