Insurance Regulatory and Development Authority (IRDA) has permitted the use of Credit Default Swap (CDS), a derivative instrument that offers credit protection, for insurance companies to hedge their risk.
New Delhi: Insurance Regulatory and Development Authority (IRDA) has permitted the use of Credit Default Swap (CDS), a derivative instrument that offers credit protection, for insurance companies to hedge their risk.
Insurers are allowed only as users (protection buyers) of CDS subject to condition, IRDA said in a final guideline for investment in CDS.
The CDS is a guarantee in which the buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product.
By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
The permission by IRDA comes almost a year after RBI allowed banks and financial institutions to deal with such instruments.
The guidelines said: "The CDS are permitted as a hedged to manage the credit risk covering the credit event. The category of the investment will not change pursuant to buying CDS on such underlying."
Insurers are allowed to use CDS on listed corporate bonds as underlying. Companies can, however, buy unlisted rated bonds of infrastructure companies. Also, insurers can invest in unlisted and unrated bonds issued by the special purpose vehicles set up by the infrastructure companies.
It has disallowed companies from any CDS transaction between entities belonging to a promoter group. Insurers cannot be purchased on short-term instruments with maturity up to one year such as commercial papers, certificates of deposit, non-convertible debentures.
Besides, the regulator directed that "all CDS transactions shall be reported to the investment committee, audit committee and to the board on a quarterly periodicity".
It also said the board of the insurance companies should amend its investment policy and put in place necessary risk management framework covering including type of assets on which protect can be bought, valuation norms and reporting and monitoring norms.
Recently, market regulator Sebi allowed mutual funds to participate in CDS transactions. Sebi said mutual funds can participate in the CDS market for hedging their debt risks, but can not enter into short positions in the CDS contracts.
In April, the Reserve Bank had allowed all financial institutions to participate in CDS market.
All India financial institutions, namely, EXIM Bank, NABARD, NHB and SIDBI were allowed to participate in the CDS market as user to hedge the underlying credit risk in corporate bonds in their portfolio, RBI had then said.