LIFE INSURANCE ACT 1995 CIRCULAR TO LIFE INSURANCE COMPANIES. No C.I.1 DERIVATIVES - USE, MANAGEMENT AND CONTROL NOVEMBER 1995

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1 LIFE INSURANCE ACT 1995 CIRCULAR TO LIFE INSURANCE COMPANIES No C.I.1 DERIVATIVES - USE, MANAGEMENT AND CONTROL NOVEMBER 1995 November LIFE No C.I.1

2 DERIVATIVES - USE, MANAGEMENT AND CONTROL Background This circular addresses controls that the Insurance and Superannuation Commission (ISC) considers are necessary where life insurance companies use derivative instruments. The ISC issued a discussion paper Derivatives for Life Insurance on 27 March 1995, the purpose of which was to present the industry with a suggested approach to the use and control of derivatives which meets the ISC goal of protecting the interests of policyholders. This circular is based on the principles set out in the discussion paper, incorporating where appropriate comments and suggestions received. The Commission does not, in general, interfere in the investment decisions made by insurers. As the use of derivatives is part of that investment process, restricting their use is inappropriate. However, because of the potential for derivatives to cause significant loss, the Commission believes that it should be the responsibility of directors to determine the appropriateness and extent of derivative use in the context of the company s overall investment strategy and put in place control mechanisms to monitor and ensure compliance with those policies. What is a derivative? For the purposes of this circular, a derivative is treated as: A financial asset or liability whose value depends on (or is derived from) other assets, liabilities or indexes (the underlying ). Derivative transactions are financial contracts and include a wide assortment of instruments, such as forwards, futures, options, swaps, exotics and other composites. It is not the Commissioner s intention to limit the scope of instruments to which this circular applies. While most derivatives fit comfortably within this definition, individual boards of directors will have to determine which other instruments should be classified as derivatives. Summary of Requirements To ensure that life companies have in place adequate controls on the use of derivatives and the necessary checks on compliance with those controls, the Commission requires the following: November LIFE No C.I.1

3 1. Regular reporting to the Commissioner on the effect of derivative use via Quarterly Statutory Fund Returns required by Commissioners Rule on Collection of Statistics (s.244(1) and (2)) dated 28 June 1995 which replaced Circular 302: 2. Life insurers using derivatives to have satisfactory risk management practices for derivatives as evidenced by a Risk Management Statement (RMS). 3. Life companies to implement satisfactory internal audit procedures and external audit arrangements to ensure compliance with and appropriate monitoring of the effectiveness of the RMS. 4. Directors Responsibilities Where derivatives are used, directors should make a specific statement in their Annual Financial Statements lodged with the ISC that they: have a Board approved RMS in place; understand its contents; have monitored its effectiveness; have received regular reports on its operations; and are satisfied with the level of compliance with the RMS. 5. Audit Requirements In the Audit Report that accompanies the Annual Financial Statements, external auditors of life companies should report on whether: an RMS is in place; and it has been complied with. The audit of Circular 302 returns which coincide with a life company s balance date will continue to be audited but its format and content will be amended to include pertinent comments on derivative usage and RMS compliance. The actual wording to be included in both audit reports is being discussed with life company auditors and will become operative as soon as agreement is reached. 6. Actuaries Responsibilities The appointed actuary s investigation and report on the financial condition of life companies at the end of every financial year should in future include consideration of the RMS, compliance with it and the impact of exposure to derivatives as part of the overall assessment of assets and liabilities. November LIFE No C.I.1

4 Risk Management Statement (RMS) A properly implemented, tight RMS is an indispensable prerequisite for the effective monitoring and control of derivatives. It should therefore be an integral part of the documented investment strategy and accompanying controls of the life company. As the Commission does not wish to impose prescriptive standards for an RMS, directors of life companies are free to determine the contents of their respective company s RMS in accordance with the extent of derivative usage and in the context of their overall internal control framework. However, Appendix A sets out some elements which the Commission believes a life company s RMS should incorporate. Restrictions on Derivative Trading The Commission recognises that the variations in derivative products are enormous. In the development of their RMS, directors of life companies should consider whether it is appropriate for their company to be involved in certain types of derivatives, particularly those which create exposures large enough to adversely affect solvency. These may include: highly leveraged derivatives; uncovered derivatives; derivatives where the potential for losses is considerably higher than the initial investment or is unlimited; derivatives where the potential exposure cannot be reliably measured; derivatives where closing out is difficult considering the illiquidity of the market; derivatives where the underlying asset is not admissible for solvency purposes. Exposure Limits All types of risks, including those mentioned in the Appendix, should be allowed for in the calculation of exposure limits. These limits should take into account the uncertainty of potential exposure inherent in derivatives. The ISC is aware of the absence of accounting standards dealing with the measurement and valuation of exposures resulting from derivatives market activity. It is therefore important that companies specify and document the techniques/methodologies used in the valuation process and use them consistently until accounting standards specific for the purpose are developed and become operative. Derivative exposure should be considered in the context of a life company s overall investment strategy. In particular, derivative exposure combined with physical exposure should not result in a net exposure which is inconsistent with the insurer s investment strategy as adopted and endorsed by the Board of Directors. November LIFE No C.I.1

5 A life company s RMS should have quantitative limits on exposure to any one counter party, any one type of derivative as well as on aggregate exposure to all derivative positions. If these limits are breached, the Board of Directors should consider the position immediately and take action appropriate to the circumstances e.g. altering derivative exposure, reassessing the appropriateness of RMS limits etc. To determine the level of exposure limits, the Board of Directors should specifically address the types of risks involved in their investment portfolio and adjust these limits accordingly. For example, the level of uncertainty caused by credit, legal and operations risk ( e.g. incorrect calculation of exposure), is significantly less for exchange traded as opposed to over-the-counter (OTC) derivatives. Therefore, an RMS governing a portfolio trading predominantly in exchange traded derivatives may allow for a higher exposure limit than if the portfolio is invested predominantly in OTC s. Implementation A number of life companies already use derivatives. It is therefore important that our objective to ensure that prudent practices are universal is met as soon as possible. Compliance with the requirements contained in this circular will become operative for all life companies using derivatives for financial years commencing after 31 December Further Information Background information can be obtained from the discussion paper Derivatives for Life Insurance released in March For a copy of this paper, please contact the Life Cross Divisional Committee on (02) RG Glading Deputy Commissioner Life Insurance November 1995 November LIFE No C.I.1

6 APPENDIX A RISK MANAGEMENT STATEMENTS (The determination of risk management strategies and the nature and extent of controls to be introduced are the responsibility of directors of life companies. Derivative control should not be viewed in isolation but rather as an integral part of the total control framework.) A life company s Risk Management Statement should include but is not limited to the following elements: be in writing and readily accessible by all people involved in derivative activities; be reprinted and re-circulated when amended; identify the objectives of the Board of Directors in using derivatives; identify the risk tolerances set by the Board of Directors; clearly delineate the lines of authority and responsibility, including trading limits; ensure all people involved in derivative activities are fully aware of the policies and procedures contained in the RMS; require that the Board of Directors approve all significant policies and procedures relating to the management of risks; require that the Board of Directors are regularly informed of significant individual exposures and the aggregate exposure (both derivatives in isolation and combined with physical exposure); Make the Board Audit Committee responsible for ensuring: authority limits are not exceeded; systems are adequate (e.g. measuring risk, monitoring limits, separation of duties); reporting is regular and comprehensive; and senior management is notified of breaches in internal control; ensure that expertise and resource levels, both personnel and systems, are sufficient; require worst case simulations and sensitivity analysis to be regularly undertaken to provide an indication of how a portfolio will react under certain circumstances, and to monitor the effectiveness of hedging techniques; provides for ISC reporting requirements; analyse all relevant types of risks including credit, market, liquidity, basis, operations, and legal risk, and provide adequately for them. In particular counterparty risk (including overseas stock and futures exchanges) should be analysed and provided for; require the Board Audit Committee to thoroughly review all risk management procedures and policies at least once a year; eliminate incentives for excessive risk taking; and contain guidelines to ensure that staff responsible for control and monitoring procedures are adequately segregated or independent from individuals conducting derivative activities and have sufficient expertise to perform their tasks. November LIFE No C.I.1