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Title XXIV BUSINESS AND FINANCIAL INSTITUTIONS

  Chapter 375back to chapter 375

  375.345.  Derivative transactions permitted, conditions — definitions — rules. — 1.  As used in this section, the following words and terms mean:

  (1)  "Admitted assets", assets permitted to be reported as admitted assets on the statutory financial statement of the insurance company most recently required to be filed with the director, but excluding assets of separate accounts, the investments of which are not subject to the provisions of law governing the general investment account of the insurance company;

  (2)  "Cap", an agreement obligating the seller to make payments to the buyer, with each payment based on the amount by which a reference price, level, performance, or value of one or more underlying interests exceeds a predetermined number, sometimes called the strike rate or strike price;

  (3)  "Collar", 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;

  (4)  "Counterparty exposure amount":

  (a)  The amount of credit risk attributable to an over-the-counter derivative instrument.  The amount of credit risk equals:

  a.  The market value of the over-the-counter derivative instrument if the liquidation of the derivative instrument would result in a final cash payment to the insurance company; or

  b.  Zero if the liquidation of the derivative instrument would not result in a final cash payment to the insurance company;

  (b)  If over-the-counter derivative instruments are entered into under a written master agreement which provides for netting of payments owed by the respective parties, and the domicile of the counterparty is either within the United States or within a foreign jurisdiction listed in the Purposes and Procedures of the Securities Valuation Office as eligible for netting, the net amount of credit risk shall be the greater of zero or the net sum of:

  a.  The market value of the over-the-counter derivative instruments entered into under the agreement, the liquidation of which would result in a final cash payment to the insurance company; and

  b.  The market value of the over-the-counter derivative instruments entered into under the agreement, the liquidation of which would result in a final cash payment by the insurance company to the business entity;

  (c)  For open transactions, market value shall be determined at the end of the most recent quarter of the insurance company's fiscal year and shall be reduced by the market value of acceptable collateral held by the insurance company or placed in escrow by one or both parties;

  (5)  "Derivative instrument", an agreement, option, instrument, or a series or combination thereof that makes, takes delivery of, assumes, relinquishes, or makes a cash settlement in lieu of a specified amount of one or more underlying interests, or that has a price, performance, value, or cash flow based primarily upon the actual or expected price, level, performance, value or cash flow of one or more underlying interests.  Derivative instruments also include options, warrants used in a hedging transaction and not attached to another financial instrument, caps, floors, collars, swaps, forwards, futures and any other agreements, options or instruments substantially similar thereto, and any other agreements, options, or instruments permitted under rules or orders promulgated by the director;

  (6)  "Derivative transaction", a transaction involving the use of one or more derivative instruments;

  (7)  "Director", the director of the department of commerce and insurance of this state;

  (8)  "Floor", an agreement obligating the seller to make payments to the buyer in which each payment is based on the amount by which a predetermined number, sometimes called the floor rate or price, exceeds a reference price, level, performance, or value of one or more underlying interests;

  (9)  "Forward", an agreement other than a future 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, but not including spot transactions effected within customary settlement periods, when issued purchases or other similar cash market transactions;

  (10)  "Future", an agreement traded on an exchange 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 and which includes an insurance future;

  (11)  "Hedging transaction", a derivative transaction that is entered into and maintained to reduce:

  (a)  The risk of economic loss due to a change in the value, yield, price, cash flow or quantity of assets or liabilities that the insurance company has acquired or incurred or anticipates acquiring or incurring;

  (b)  The currency exchange rate risk or the degree of exposure as to assets or liabilities that the insurance company has acquired or incurred or anticipates acquiring or incurring; or

  (c)  Risk through such other derivative transactions as may be specified to constitute hedging transactions by rules or orders adopted by the director;

  (12)  "Income generation transaction":

  (a)  A derivative transaction involving the writing of covered call options, covered put options, covered caps or covered floors that is intended to generate income or enhance return; or

  (b)  Such other derivative transactions as may be specified to constitute income generation transactions in rules or orders adopted by the director;

  (13)  "Initial margin", the amount of cash, securities or other consideration initially required to be deposited to establish a futures position;

  (14)  "NAIC", the National Association of Insurance Commissioners;

  (15)  "Option", an agreement giving the buyer the right to buy or receive, sell or deliver, enter into, extend, terminate or effect a cash settlement based on the actual or expected price, level, performance or value of one or more underlying interests;

  (16)  "Over-the-counter derivative instrument", a derivative instrument entered into with a business entity other than through an exchange or clearinghouse;

  (17)  "Potential exposure", the amount determined in accordance with the NAIC Annual Statement Instructions;

  (18)  "Replication transaction", a derivative transaction effected either separately or in conjunction with cash market investments included in the insurer's investment portfolio and intended to replicate the investment characteristic of another authorized transaction, investment or instrument or to operate as a substitute for cash market transactions.  A derivative transaction that is entered into as a hedging transaction or an income generation transaction shall not be considered a replication transaction;

  (19)  "SVO", the Securities Valuation Office of the NAIC or any successor office established by the NAIC;

  (20)  "Swap", an agreement to exchange or to net payments at one or more times based on the actual or expected price, level, performance or value of one or more underlying interests;

  (21)  "Underlying interest", the assets, liabilities, other interests, or a combination thereof underlying a derivative instrument, such as any one or more securities, currencies, rates, indices, commodities or derivative instruments;

  (22)  "Warrant", an instrument 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 outlined in the warrant agreement.

  2.  An insurance company, including those organized under chapter 376, may, directly or indirectly through an investment subsidiary, engage in derivative transactions pursuant to this section under the following conditions:

  (1)  In general:

  (a)  An insurance company may use derivative instruments pursuant to this chapter to engage in hedging transactions and certain income generation transactions;

  (b)  Upon request, an insurance company shall demonstrate to the director the intended hedging characteristics and the ongoing effectiveness of the derivative transaction or combination of the transactions through cash flow testing or other appropriate analyses;

  (2)  An insurance company shall only maintain its position in any outstanding derivative instrument used as part of a hedging transaction for as long as the hedging transaction continues to be effective;

  (3)  An insurance company may enter into hedging transactions if as a result of and after giving effect to the transaction:

  (a)  The aggregate statement value of options, caps, floors and warrants not attached to another financial instrument purchased and used in hedging transactions then engaged in by the insurer does not exceed seven and one-half percent of its admitted assets;

  (b)  The aggregate statement value of options, caps and floors written in hedging transactions then engaged in by the insurer does not exceed three percent of its admitted assets; and

  (c)  The aggregate potential exposure of collars, swaps, forwards and futures used in hedging transactions then engaged in by the insurer does not exceed six and one-half percent of its admitted assets;

  (4)  An insurance company may only enter into the following types of income generation transactions if as a result of and after giving effect to an income generation transaction, the aggregate statement value of the fixed income assets that are subject to call or that generate the cash flows for payments under the caps or floors, plus the face value of fixed income securities underlying a derivative instrument subject to call, plus the amount of the purchase obligations under the puts, shall not exceed ten percent of its admitted assets:

  (a)  Sales of covered call options on noncallable fixed income securities, callable fixed income securities if the option expires by its terms prior to the end of the noncallable period, or derivative instruments based on fixed income securities;

  (b)  Sales of covered call options on equity securities if the insurance company holds in its portfolio or can immediately acquire through the exercise of options, warrants or conversion rights already owned, the equity securities subject to call during the complete term of the call option sold;

  (c)  Sales of covered puts on investments that the insurance company is permitted to acquire under the applicable insurance laws of the state, if the insurance company has escrowed or entered into a custodian agreement segregating cash or cash equivalents with a market value equal to the amount of its purchase obligations under the put during the complete term of the put option sold; or

  (d)  Sales of covered caps or floors if the insurance company holds in its portfolio the investments generating the cash flow to make the required payments under the caps or floors during the complete term that the cap or floor is outstanding;

  (5)  An insurance company may use derivative instruments for replication transactions only after the director promulgates reasonable rules that set forth methods of disclosure, reserving for risk-based capital, and determining the asset valuation reserve for these instruments.  Any asset being replicated is subject to all the provisions and limitations on the making thereof specified in this chapter and chapters 376 and 379 with respect to investments by the insurer as if the transaction constituted a direct investment by the insurer in the replicated asset;

  (6)  An insurance company shall include all counterparty exposure amounts in determining compliance with this state's single-entity investment limitations;

  (7)  The director may approve, by rule or order, additional transaction conditions involving the use of derivative instruments for other risk management purposes.

  3.  Written investment policies and record-keeping procedures shall be approved by the board of directors of the insurance company or by a committee authorized by such board before the insurance company may engage in the practices and activities authorized by this section.  These policies and procedures must be specific enough to define and control permissible and suitable investment strategies with regard to derivative transactions with a view toward the protection of the policyholders.  The minutes of any such committee shall be recorded and regular reports of such committee shall be submitted to the board of directors.

  4.  The director may promulgate reasonable rules and regulations pursuant to the provisions of chapter 536, not inconsistent with this section and any other insurance laws of this state, establishing standards and requirements relating to practices and activities authorized in this section, including, but not limited to, rules which impose financial solvency standards, valuation standards, and reporting requirements.

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(L. 1985 H.B. 823, A.L. 2002 S.B. 1009, A.L. 2007 S.B. 66)


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