The American Council Life Insurers (ACLI) is suggesting a 3-tier system for classifying derivatives used to hedge insurer asset risk.

The ACLI, Washington, has included that idea in a proposal concerning ways to handle derivatives-based asset hedging strategies in risk-based capital (RBC) calculations.

A derivative is a financial instrument that derives its value from some other financial instrument.

Hedging is a technique used in an effort to reduce financial risk.

The RBC ratio system is a method the National Association of Insurance Commissioners (NAIC), Kansas City, Mo., and state insurance regulators use to determine whether an insurer has enough capital to support its operations, given the amount of risk it is taking.

Panels at the NAIC have been looking into the possibility of updating the RBC ratio system rules. The NAIC also has been studying the idea of revising Model Regulation 282, which deals with derivatives.

A team at the ACLI led by Walter Givler, a vice president of accounting policy at Northwestern Mutual Life Insurance Company, Milwaukee, developed the derivatives report in an effort to provide a method for building derivatives-based risk-management programs into the RBC calculations.

The ACLI team notes that its recommendations apply only to “C-1 asset risk,’ or risk resulting from issuer defaults or loss of market value, related to fixed-income securities and common stocks.

The team talks about classifying derivatives in 3 groups:

- Basic hedging strategies, or hedges that pair single assets and derivatives.

- Intermediate hedging strategies, or hedges that pair a portfolio of assets with a very closely matched basket or index-based derivative containing the same or very similar components as the asset portfolio.

- Advanced hedging strategies, or strategies that cannot be measured using the basic or intermediate methods, such as transactions involving tranches or equity options.

The “ACLI is not making recommendations concerning advanced hedging at this team,” the ACLI team says.

For basic and intermediate hedges, the ACLI would allow credit for the effects of hedging but limit the credit to reflect the risks that remain despite the use of the hedging program.

Some of the residual risks include the risk that a counterparty will default; the risks resulting from the use of shorter-dated credit default swaps to match long-term bonds, because a scarcity of longer-term bonds; and general business risk, the ACLI team says.

The ACLI would express the derivatives RBC credit as a percent of the C-1 asset charge, or the amount an insurer must cut off the statement value of an investment when adjusting the statement value for estimated level of risk.

For credit default swaps, for example, the team would divide the time remaining until the swap matures by the time remaining until the underlying bond matures, multiply that result by 84%, then add 10%.

For a complete hedge on a specific common stock, the ACLI team would set the RBC credit at 94% of the C-1 asset charge.

An intermediate hedge would be treated as a group of basic hedges.

In appendices, the ACLI team addresses topics such as how insurers use derivatives and how indexed credit default swap hedges work.