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Life/A&H/Fraternal Financial Analysis Handbook – Annual 2012 / Quarterly 2013
III. Analyst Reference Guide – B.1A. Investments Appendix – Primer on Derivatives
Primer on Derivatives
Derivative instruments are financial instruments whose value and cash flows are based on other financial
instruments, indices or statistics. Based on the current insurance regulatory framework, this definition is too
broad. For example, some people call Collateralized Mortgage Obligations (CMOs), “mortgage-backed
derivatives,” because the value and cash flows of a CMO are based on the value and cash flows of a pool of
mortgages. For insurance regulatory purposes, only options, caps, floors, forwards, futures, swaps, collars and
similar instruments are considered derivative instruments. The definitions of these instruments are contained in
NAIC Accounting Practices and Procedures Manual (AP&P Manual).
This primer will concentrate on options, futures and swaps. It will describe the instruments from an operational
standpoint and from a use standpoint. It will also discuss how derivative instruments are reported in statutory
financial statements. Accounting will be discussed only in general terms. A discussion of accounting details is
provided in SSAP No. 86—Accounting for Derivative Instruments and Hedging Activities.
Derivative Instrument Basics
Options
An option is an agreement giving the buyer the right to buy or receive, sell or deliver, enter into, extend or
terminate, or effect a cash settlement based on the actual or expected price level, performance or value of,
one or more underlying interest. Underlying interest is the asset(s), liability(ies), or other interest(s)
underlying a derivative instrument, including, but not limited to, any one or more securities, currencies,
rates, indicies, commodities, derivative instruments, or other financial market instruments.
An insurer can either purchase an option or write (sell) an option. When an insurer buys an option, the
insurer pays a premium for a right, but not an obligation, to exercise the option at a strike. When an
insurer writes (sells) an option, the insurer receives a premium from the other party to the transaction
(counterparty). The counterparty has the right, but not the obligation, to exercise the option at the strike.
An example will help to illustrate these concepts.
Consider an insurance company that sells equity indexed annuities. The equity indexed annuity provides a
floor guarantee as to interest with an additional guarantee that the policyholder will participate in the
upside of an equity index if the growth in the equity index exceeds the guaranteed interest.
An insurer can purchase an option to hedge the equity risk in the annuity contract. The option purchased
would be based on the same equity index as the annuity contract. The level of the strike in the option
would be based on the amount determined by the guaranteed interest rate, the participation rate in the
annuity contract, and any cap on index growth. If the index grew at a rate greater than the guaranteed
interest rate in the annuity contract, the insurer would exercise the option to cover the equity indexed
based obligation in the annuity contract. If the holder of the option does not exercise the option, the
holder’s downside is limited to the initial premium paid for the option.
Futures
A futures contract is an agreement traded on an exchange, board of trade, or contract market, to make or
take delivery of, or effect a cash settlement, based on the actual or expected price, level, performance, or
value of one or more underlying interests.
Futures contracts are different from options in that an insurer entering a futures contract will participate in
both gains and losses in the underlying financial instrument as measured from the date the futures contract
is opened. For example, if an insurer takes a long position in U.S. Treasury futures, the insurer will
experience any gains or losses in the U.S. Treasury futures (the underlying) as measured from the date of
opening the position. If interest rates increase after the futures contract is opened, the U.S. Treasuries will
© 1998-2013 National Association of Insurance Commissioners
Life/A&H/Fraternal Financial Analysis Handbook – Annual 2012 / Quarterly 2013
III. Analyst Reference Guide – B.1A. Investments Appendix – Primer on Derivatives
decrease in value and the insurer will have to make a payment to the counterparty. On the other hand, if
interest rates move down, the insurer will receive a payment from the counterparty. Since the insurer
shares in both the upside and downside of the futures contract, the insurer does not pay a premium when
entering a futures contract. If the futures contract is exchange traded, the insurer will typically put up a
deposit in cash or securities. This deposit is to protect the counterparty in the event the insurer cannot
make required payments.
Insurers exposed to interest rate risk can take short positions in U.S. Treasury futures contracts. In this
case, the insurer receives payments if interest rates increase and makes payments if interest rates decrease.
This is opposite of the situation when the insurer takes a long position. However, going short U.S.
Treasury futures can hedge the interest rate risk exposure on bonds that the insurer holds in its portfolio.
This is especially important for GAAP accounting purposes when bonds are reported on a fair value basis.
In the discussion above, taking a “long” position has the same financial characteristics as buying the
underlying instrument (in this case a bond). Taking a “short” position has the financial characteristics of
short selling the underlying instrument (in this case a bond).
Swaps
A swap contract is an agreement to exchange or net payments at one or more times based on the actual or
expected price, level, performance, or value of one or more underlying interests. A typical example is a
fixed or floating swap. An insurer can make payments to a counterparty based on a fixed rate, for example
6 percent, semi-annually and receive a floating London Inter Bank Offer Rate (LIBOR), for example, plus
a spread. Each six months, the insurer would pay the counterparty 3 percent times the notional amount,
$10,000,000 for example, and would receive an amount equal to $10,000,000 times the then current
LIBOR rate plus a spread. Of course, the amounts are netted so that a single payment is made by one
party to the other party. Depending on the LIBOR rate at any payment determination date, the insurer
may be making or receiving a payment. In swap transactions, the rates and spread are set so that neither
party pays an up-front premium to open the transaction. Also, the notional amount is never exchanged.
The floating rate of a swap transaction can be based on a multitude of different financial indices or rates.
For example, in a credit swap transaction, the floating rate can be based on the total rate of return of a
junk bond portfolio. In effect, the party that is paying the fixed rate can be exposed to junk bond market
risk through a transaction of this type.
Caps/Floors
A cap is an agreement obligating the seller to make payments to the buyer. Each payment under which is
based on the amount, if any, that a reference price, level, performance, or value of one or more underlying
interests exceed a predetermined number, sometimes called the stike/cap rate or price. A floor is an
agreement obligating the seller to make payments to the buyer. Each payment under which is based on the
amount, if any, that a predetermined number, sometimes called the strike/floor rate or price, exceeds a
reference price, level, performance, or value of one or more underlying interests. Caps and floors are
similar to options in that one party, the purchaser of the instrument, pays a premium and receives a
payment from the other party if an index exceeds the “cap” or falls below the “floor” a specified value, or
“strike”. An insurer might purchase a floor to protect itself against interest rates falling below the
guarantees in the annuity contracts it has sold. An insurer can either buy or write (sell) caps or floors.
Collars
A collar is an agreement to receive payments as the buyer of an option, cap, or floor and to make
payments as the seller of a different option, cap, or floor. An insurer could buy a collar that includes the
purchase of a cap and the sale of a floor. In effect, the insurer is protecting itself against an increase in
interest rates and paying for the protection by selling the floor.
© 1998-2013 National Association of Insurance Commissioners
Life/A&H/Fraternal Financial Analysis Handbook – Annual 2012 / Quarterly 2013
III. Analyst Reference Guide – B.1A. Investments Appendix – Primer on Derivatives
Forwards
A forward is an agreement (other than futures) to make or take delivery of, or effect a cash settlement
based on the actual or expected price, level, performance or value of, one or more underlying interests. It
is an over-the-counter transaction as opposed to traded on an exchange, which makes it less liquid. It is
customized to meet the needs of both parties whereas contracts traded on an exchange are standardized.
Warrants
A warrant is an agreement that gives the holder the right to purchase an underlying financial instrument at
a given price and time (or at a series of prices and times) according to a schedule or warrant agreement.
Uses of Derivative Instruments
Besides analyzing derivative instruments from an operational standpoint, they can be analyzed by their use. From
an insurance regulatory perspective, derivative instruments can be used in four ways: hedging, income generation,
replication of other assets, and speculation. Rules concerning and income generation transactions are included in
the NAIC Investments of Insurers Model Act (Defined Limits Version) (#280) and the AP&P Manual (SSAP No.
86).
Hedging
For a derivative instrument to qualify for hedge accounting, the item to be hedged must expose the
company to a risk and the designated derivative transaction must reduce that exposure. Examples include
the risk of a change in the value, yield, price, cash flow, quantity of, or degree of exposure with respect to
assets, liabilities, or future cash flows which an insurer has acquired or incurred, or anticipates acquiring
or incurring.
Some insurance companies that sell Guaranteed Investment Contracts (GICs) guarantee to the GIC
contract holders an interest rate on future contributions for a specified period of time. The risk associated
with this type of guarantee is that interest rates may drop before the GIC contract holder makes an
additional contribution. The insurer can hedge this risk by using futures contracts.
Income Generation
Income generation transactions are defined as derivatives written or sold to generate additional income or
return to the insurer. They include covered options, caps, and floors (e.g., an insurer writes an equity call
option on stock which it already owns).
Because these transactions require writing derivatives, they expose the insurer to potential future
liabilities for which the insurer receives a premium up front. Because of this risk, dollar limitation and
additional constraints are imposed requiring that the transactions be “covered” (i.e., offsetting assets can
be used to fulfill potential obligations). To this extent, the combination of the derivative and the covering
asset works like a reverse hedge where an asset owned by the insurer in essence hedges the derivative
risk.
An example is the writing (selling) of call options that are covered. Covering the call option means that
the insurer writing (selling) the options owns the financial instruments or the rights to the financial
instrument that can be called by the option holder. The insurer writing (selling) the option earns a profit
(the premium) if the option is not exercised by the other party. If the option is exercised, the financial
instrument subject to call is paid to the holder of the option. From a risk/return standpoint, writing a
covered call generates income in the same way that a callable bond does as compared to a non-callable
bond.
As with derivatives in general, these instruments include a wide variety of terms regarding maturities,
range of exercise periods and prices, counterparties, underlying instruments, etc.
© 1998-2013 National Association of Insurance Commissioners
Life/A&H/Fraternal Financial Analysis Handbook – Annual 2012 / Quarterly 2013
III. Analyst Reference Guide – B.1A. Investments Appendix – Primer on Derivatives
Replication
The basic idea behind replication transactions is to combine the cash flows from a derivative instrument
and another financial instrument to replicate the cash flows of another financial instrument. The following
is a typical example of a replication transaction: the insurer holds a high quality corporate bond that pays
one 7 percent coupon per year. The insurer can enter into a swap transaction with another party in which
the insurer receives 2 percent of the notional amount of the swap each year and, in turn, pays the
counterparty the drop in fair value of a specific junk bond that would result if the junk bond would
default. The insurer does not own the junk bond, but the combined cash flows of the high-grade corporate
bond and the swap transaction replicate the cash flows of a junk bond.
Reporting of Derivative Instruments
On an annual basis, derivative instruments are reported in Schedule DB of the statutory financial statement.
Options, caps, floors, collars, swaps and forwards are reported in Part A. Future contracts are reported in Part B,
replications are reported in Part C, and counterparty exposure for derivatives instruments are reported on Part D.
Schedule DB, parts A and B contain two sections: 1) Section 1 identifies the contracts open as of the accounting
date, and 2) Section 2 identifies contracts terminated during the year.
Schedule DB – Part C – Section 1 contains the underlying detail of replicated assets owned at the end of the year.
Schedule DB – Part C – Section 2 is a reconciliation between years of replicated assets. The assumption
underlying the NAIC RBC formula, that all derivative instruments are used for hedging purposes, is a central
issues the NAIC is exploring in its revised disclosure in Schedule DB, and one that is being researched further.
Schedule DB – Part D – Section 1 of the annual statement is different. It collects information necessary for RiskBased Capital (RBC) purposes. Currently, the NAIC RBC formula assumes that all derivative instruments are
used for hedging purposes and the only risk exposure to the insurer is that the counterparty may not perform
according to the terms of the contract. The concepts of Potential Exposure and Off-Balance Sheet Exposure have
been defined to quantify the risk of non-performance by the counterparty. The definition of these concepts is
contained in the Blanks Instructions.
On a quarterly basis, the insurer only reports derivative instruments that are open as of the current statement date.
Schedule DB – Part A – Section 1 lists the insurer’s open options, caps, floors, collars, swaps and forwards. Open
futures are reported in Schedule DB – Part B – Section 1, replications are reported in Schedule DB – Part C –
Section 1, and counterparty exposure for derivatives instruments are reported in Schedule DB – Part D.
Accounting
Statutory accounting guidance for derivative instruments used for hedging and income generation transactions is
contained in the AP&P Manual. Beginning in 2003, accounting guidance for derivative transactions will vary
based on the transaction or modification date of the transaction. For derivative transactions effective Jan. 1, 2003
and after, SSAP No. 86 will apply. The insurer is to disclose the transition approach that is being used. In order
for a derivative instrument to qualify for hedge accounting treatment, the item to be hedged must expose the
insurer to a risk and the designated derivative transaction must reduce that exposure.
An insurer should set specific criteria at the inception of the hedge as to what will be considered “effective” in
measuring the hedge and then apply those criteria in the ongoing assessment based on actual hedge results. The
penalty for failure to meet the effectiveness criteria varies from state to state.
The NAIC accounting guidance includes a discussion of required documentation. One item that is not mentioned
is the “term sheet.” The term sheet is a document signed by both parties to an over-the-counter derivative
© 1998-2013 National Association of Insurance Commissioners
Life/A&H/Fraternal Financial Analysis Handbook – Annual 2012 / Quarterly 2013
III. Analyst Reference Guide – B.1A. Investments Appendix – Primer on Derivatives
transaction such as a swap. The term sheet contains a detailed description of all of the terms and conditions of the
swap transaction.
In many cases, an insurer will enter into several over-the-counter transactions with a single party. In this situation,
the insurer should have entered into a master netting agreement. The existence of such an agreement has
implications for Risk Based Capital.
Comprehensive Description of a Hedging Program
When an insurer is actively engaged in derivative activity or when concerns exsist regarding an insurer’s
derivative activity it may be necessary to obtain a comprehensive description of the insurer’s derivative program,
a procedure included in the Level 2 Procedures.
States may have specific requirements for items to be included in a comprehensive description of an insurer’s
derivative program. Items may include detailed information on the following:

Authorization by the insurer’s board of directors, or other similar body to engage in derivative activity.

Management oversight standards including risk limits, controls, internal audit, review and monitoring
processes.

The adequacy of professional personnel, technical expertise and systems.

The review and legal enforceability of derivative contracts between parties.

Internal controls, documentation and reporting requirements for each derivative transaction.

The purpose and details of the transaction including the assets or liabilities to which the transaction
relates, specific derivative instrument used, the name of the counterparty and counterparty exposure
amount, or the name of the exchange and the name of the firm handling the trade.

Management’s written guidelines for engaging in derivative transactions, for example:

Type, maturity, and diversification of derivative instruments.

Limitations on counterparty exposures.

Limitations based on credit ratings.

Limitations on the use of derivatives.

Asset and liability management practices.

The liquidity and capital and surplus needs of the insurer as it relates to derivative activity.

The relationship of the hedging strategies to the insurer’s operations and risks.

Guidelines for the insurer’s determination of acceptable levels of basis risk, credit risk, foreign currency
risk, interest rate risk, market risk, operational risk, and option risk.

Guidelines that the board of directors and senior management comply with risk oversight functions and
adhere to laws, rules, regulations, prescribed practices, or ethical standards.
© 1998-2013 National Association of Insurance Commissioners