Reckoning the fact that investing in the debt market entails risk such as interest rate risk, default risk, inflation risk, liquidity risk and re-investment risk, amongst host of other economic risks as well; recently the Insurance Regulatory and Development Authority of India (IRDA) proposed to allow Credit Default Swap (CDS) on listed corporate bonds as reference obligation. However, the draft guidelines permit the use of CDS only for the purposing of hedging, whereby insurers can only be "users” (i.e. protection buyers) of CDS, which could enable them to manage their credit risk well.

The draft guidelines also allow insurers to buy CDS of unlisted but rated bonds of "infrastructure companies”. Besides, unlisted/unrated bonds issued by the Special Purpose Vehicles (SPVs) set up by the infrastructure companies are also eligible as reference obligation. However, the insurers will not be permitted to purchase CDS if:
 

• They belong to a promoter group or between the entities of a promoter group
• On short term instruments with original maturity up to one year (viz. commercial papers, certificate of deposit, non-convertible debentures with original maturity less than one year, etc.)
• On obligations such as asset-backed securities/mortgage-backed securities, convertible bonds and bonds with call/put options, CLOs, CDOs or any other pool of assets/loans.
   

It is noteworthy that CDS is a credit derivative contract, wherein transfer of credit risk of fixed income products between parties takes place. The buyer of the contract makes payment until maturity of the contract and therefore receives a credit protection, while the seller in return agrees to pay off third party defaults on loan.

As far as disclosure of CDS transactions is concerned, insurers would be required to report such transactions to their investment committee and audit committee on a quarterly basis. Also the insurance regulator has asked the board of directors of insurers to amend their investment policy and put in place the necessary risk management framework covering aspects such as types of assets on which protection can be bought, counter-parties from which CDS can be bought and limits on the counter-parties, and valuation norms, among others.

We are of the view that by allowing insurers to buy CDS as protection buyers, it would indeed help them to manage their credit risk well, especially for longer maturity products. Moreover the exclusions for CDS transaction(s) as enunciated above, is an acceptable risk control mechanism and could help insurers to pan out and manage longer maturity products. But it is noteworthy that the flip side of holding a credit derivative product such as CDS could also prove to be detrimental, if not strategized appropriately. So, while CDS is good for insurers to hedge their risk, how they indeed strategise their investments is vital in managing the risk.

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