Indian debt markets have been witnessing a U-turn as far flow of foreign capital is concerned. From net buyers a few weeks back; Foreign Institutional Investors have turned net sellers nowadays. Concerns over India’s worsening Current Account Deficit (CAD) and weak rupee may cap the scope of further rate cuts going forward and in worst case, RBI may even think about tightening interest rates if the Government policy framework remains sloppy and India fails to attract greater FII inflows. Yields on 2023, 7.16% benchmark sovereign bond hardened to 7.42% recently. Such drastic changes in yields push bond prices down. Longer the maturity of the paper, greater would be the impact on bond prices. Clearly, those managing debt assets have a tough time ahead.

In India, Insurance companies have a massive exposure to government as well as corporate debt. As per mandate, life insurance companies invest atleast 25% of their assets in Central Government securities. For pension funds, annuity and group businesses the prescribed limit is even higher. Although insurers have a stable asset base of investors who are in for the long term, volatility in interest rates and obscure outlook impacts their performance. Citing this reason, Insurance Regulatory and Development Authority (IRDA) has proposed to let insurance companies hedge their risk more effectively.

At present, Insurers are allowed to hedge their debt portfolios by investing in derivative instruments which include:
 

• Forward Rate Agreements (FRAs)
• Interest Rate Swaps (IRS)
• Exchange Traded Interest Rate Futures
   

The maximum permissible tenure of such derivative instruments is earmarked as 1 year as of now. But IDRA has proposed to allow insurance companies to enter derivative contracts with a maximum tenure of 10 years. Moreover, the proposed guidelines would also be applicable to forecasted transactions which would help cover interest rate risk the fund may be exposed to after taking into account premium income receivable. The main reasons behind this move, as highlighted by IRDA, are:
 

• Changes in investment environment
• Changes in product structures
• Changes in guidelines by the sectorial regulators such as RBI
• Representations from some of the insurers to revisit earlier guidelines
   

To ensure interest of policy holders is protected; IRDA has also laid guidelines with regard to risk management policy and processes that need to be followed by the insurance companies. This involves assessing overall risk appetite of the insurance company before investing in derivatives and making sure that it is consistent with its strategic objectives and capital strengths. It is also expected that the insurer sets applicable stop loss and value at risk (VAR) limits. As per IRDA norms, proposed guidelines shall in aggregate not exceed an outstanding notional principal amount equivalent to 100% of the book value of the fixed income instruments of the participants under the policy holders fund and the shareholders fund taken together. Furthermore, the insurance companies will have to submit a quarterly report to IRDA in case they invest in any Rupee Interest Rate Derivative.

PersonalFN is of the view that aforesaid proposed guidelines are a welcome move. They may help insurance companies mitigate their risk by taking exposure to derivative contracts with longer expiries. The proposal has come at a time when there is uncertainty about future course of market action. RBI would have a difficult choice to make between promoting growth and supporting rupee. Given the fact that the external factors that have caused rupee to move down may stay longer than expected; we might see some negative surprises at monetary policy reviews over next few quarters. If accepted, proposed guidelines would work in favour of investors. However, effectiveness of these guidelines would depend on how the fund managers put them to use.

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