Insurers likely to prefer bond forwards over forward-rate agreements

Irdai allows insurers to hedge interest rate risks with bond forwards

Insurance companies are likely to move towards forward trading in bonds (bond forwards) from forward-rate agreements (FRAs) with the regulator allowing them to undertake transactions in the former for hedging interest-rate risks, according to industry participants.

 

In a circular, the Insurance Regulatory and Development Authority of India (Irdai) has said in view of the Reserve Bank of India’s (RBI’s) directions and considering insurers’ requests for introducing bond forwards, insurers are permitted to undertake transactions in them.

 

At present, insurers are allowed to use FRAs, interest-rate swaps, and exchange-traded interest rate futures to hedge interest-rate risks.

 

Generally, whenever an FRA is settled, the settlement is in cash, determined by the difference between the contracted yield and the market yield. However the insurer also has to procure the bond from the market to satisfy its hedging requirements.

 

In the case of bond forwards, instead of a cash settlement, the bank will deliver the bond on the date of maturity at the specified contracted yield.

 

This reduces settlement risks for the insurers on account of the bond not being available in the market at contract maturity.

 

“Insurers will be drawn towards bond forwards. I think it needs to be seen whether banks will be allowed to do FRAs once bond forwards come into force. Or else why have two products serving the same purpose,” said Rahul Bhuskute, chief investment officer, Bharti AXA Life Insurance.

 

In February, the RBI had issued directions specifying that any entity that can be classified as a non-retail user would be eligible to undertake transactions in forward contracts in government securities (bond forwards) as a user.

 

“FRAs have been prevalent in the market for the past few years. But they are settled in cash at the end of maturity and we have to go looking for the bond in the market. In the case of bond forwards, the underlying will be delivered to us on the same day of maturity. This reduces the risk of the bond not being available in the market,” said another investment official of a private life insurer.

 

However, Irdai has said insurers should undertake only long positions in bond forwards and report such transactions on a quarterly basis.

 

Bond forwards will not be allowed in unit-linked insurance plans. 

A step ahead

 

> Insurance permits insurers to trade in bond forwards for hedging interest-rate risks, aligning with RBI guidelines

> Bond forwards provide actual bond delivery at maturity, unlike forward-rate agreements (FRAs), which settle in cash

> This reduces settlement risks for insurers, eliminating the need to procure bonds separately

> Industry experts expect insurers to favor bond forwards over FRAs, potentially making FRAs redundant

> Only long positions are allowed in bond forwards, and insurers must report transactions quarterly

> Bond forwards will not be allowed in unit-linked insurance plans