Introduction

In accordance with section 7 (2), second sentence, of the VAG, and with circular R 7/95 ( VerBAV 1996, page 5), insurers are permitted to make pre-emptive purchases and use derivative financial instruments.

A revision of circular R 7/95 became necessary after the experience made with its regulations, and following the inclusion of certain structured products through circular R 3/99. The revision is aimed in particular at adjusting the volume limits so as to enable the insurance companies also in future to make pre-emptive purchases and use derivative financial instruments in a responsible and appropriate manner.

A. References to operations permitted under section 7 (2), second sentence, of the VAG

I. Pre-emptive purchases

1. General

   Pre-emptive purchases are operation-preparing acquisitions within the meaning of section 7 (2), second sentence, of the VAG. They serve to balance short-term liquidity fluctuations, to avoid disturbances of the market in the case of high investment requirements and to steady the investment.

2. Definition

   The pre-emptive purchase of bearer bonds, registered bonds, loans against borrowers' notes or other fixed-interest securities is a binding transaction where a fixed interest rate is agreed on conclusion of the contract and only the value date is deferred.

3. Admissible operations

   Pre-emptive purchases are admissible on the following conditions:

   • Pre-emptive purchases must be carried out with a view to balancing short-term liquidity fluctuations, to avoid disturbances of the market or to steady the investment. Pre-emptive purchases for speculation purposes are not admissible. They are in particular not admissible if they are intended to be sold at an early date with the purpose of realising a profit.
   • The volume of pre-emptive purchases must be limited such that it is covered by the expected liquidity inflow at the value date.
   • In principle, the period between the conclusion of the contract and the agreed value date must not exceed twelve months. The BAV has to be informed if a longer period has been agreed.
   • Pre-emptive purchases (including prolongations) covering a period of up to twelve months shall be limited to 7.5 per cent, and pre-emptive purchases exceeding this period to 5 per cent of the total investments as at the latest balance-sheet date. Total pre-emptive purchases may not exceed a maximum of 10 per cent of the said total investments. Already matched positions are to be disregarded in the calculation of the percentages.
     

II. Use of financial derivatives

1. General

   The provisions of section 7 (2), second sentence, of the VAG are explained in the following. It will be shown under what conditions essential criteria of the statutory regulations can be considered to have been met.

2. Definition: Financial derivatives

   Operations involving financial derivatives comprise all operations whose price is determined by the underlying instrument being traded (stocks, fixed-interest securities and foreign exchange), the reference price, the reference interest-rate or the reference index. Financial derivatives are either binding agreements between two parties (forward operations) or legal transactions imposing an obligation only on one party (options). Where financial derivatives are linked to traded instruments there may be a physical delivery or cash settlement at the due date, the latter being based on current market prices.

3. Admissible operations involving financial derivatives in accordance with section 7 (2), second sentence, of the VAG

   Pursuant to section 7 (2), second sentence, of the VAG forward operations, operations with options and similar financial instruments are admissible "if they are aimed at helping cover risks of changes in prices or rates for actually held assets or negotiable instruments which are to be acquired at a later date or achieving an additional yield for negotiable instruments which are actually held whereby the possibility of insufficient coverage of the restricted assets cannot occur when obligations to deliver are fulfilled."

   Operations involving financial instruments are not admissible if they are merely intended to build up pure trading positions (arbitrage operations), or if the corresponding securities are not actually held or are not built up as in the case of acquisition-preparing operations (so-called bear operations).

   The derivative financial instruments which are mentioned in this circular and others which the Federal Insurance Supervisory Office deems admissible are listed in the table in Annex 1. Amendments to this table will be published in the Official Bulletin (VerBAV) of the BAV. To decide if derivative financial instruments which are not listed in that table are admissible please refer, in the individual case, to the provisions of section 7 (2), second sentence, of the VAG and the present guidelines.

   1. Hedging operations

      Hedging operations are transactions where derivatives are used in order to completely or partly hedge a company's portfolio of capitalised assets against the risks of future fluctuations of prices and interest rates. The risks of future fluctuations of prices and interest rates cover both the risk of changes in the value of assets to be hedged and the cash flow risk. Although the law only refers to the assets side of the balance sheet it must be concluded that it is within the meaning and purpose of the law to apply these regulations also to the liabilities side. Therefore, operations involving derivatives which serve to protect the balance sheet value of technical provisions and commitments from the additional costs that might otherwise be caused by currency fluctuations have to be classified as hedging operations as well.

      When the hedging operation is being undertaken, and during the term of the financial derivative used for hedging purposes the balance sheet items to be hedged must be matched by adequate volumes of the hedging instrument. If this balance no longer exists because, for instance, hedged stocks have been sold, the hedging instrument must also be sold or closed out unless it is used for other hedging purposes or acquisition-preparation operations.

      Suitable hedging strategies within the meaning of the law could be for the assets side of the balance sheet a long put, the put position in the case of futures contracts as well as interest rate and currency swaps and combined interest and currency swaps. For the liabilities side these could be a long call, the call position of futures contracts as well as currency swaps and combined interest rate and currency swaps. However, as regards long calls there is a limitation to the effect that options which at the time of acquisition of the option exceed the spot price by more than 15 per cent are not admissible.

      The volume of balance sheet items hedged by these instruments may not exceed 100 per cent of the portfolio of assets as at the latest balance-sheet date as well as provisions and liabilities denominated in foreign currencies which are not covered by matching capital investments.

   2. Acquisition-preparation operations

      Acquisition-preparation means that the insurance company provides itself with the possibility of acquiring specific securities (underlying assets) at some point in the future.

      These conditions are met in the case of a long call and when interest rate, stock or currency futures are bought.

      As regards long calls there is a limitation to the effect that acquiring an option whose reference price at the time of acquisition exceeds the spot price by more than 15 per cent is not admissible.

      A special form of acquisition-preparation is a short put because the insurance company enters into a purchase obligation without acquiring an acquisition right. Short puts for the purpose of acquisition-preparation operations are admissible only under certain conditions and within narrow limits:

      aa) The exercise price of options must be selected such that if the prices of the securities (underlying assets) develop as expected exercise of the options may be counted on.

      bb) In the case of a short put the maximum price at which the company is prepared to acquire the securities has to be documented in a verifiable manner. It must be evident from the price chosen that the actual motive behind the short put is the actual acquisition of the securities and that it is not intended simply to enhance the yield by the earned option premium or parts thereof. This is the case if it has documented its preparedness to acquire the securities at least up to a price which is the result of exercise price minus option premium.

      cc) In principle, closing out before the price calculated in accordance with bb), third sentence (above) has been reached is not admissible and special reference shall be made in such a case and the reasons be specified when documenting as above.

      dd) Short puts are not admissible unless the resulting obligation to acquire the securities may be covered by the expected liquidity inflow.

      Acquisition-preparing operations must be limited to a maximum of 7.5 per cent of the total asset portfolio as at the latest balance-sheet date. Short puts are limited in total to 1.5 per cent of the asset portfolio as at the latest balance-sheet date. Shorts puts based on stocks are limited to 0.5 % of the afore-mentioned asset portfolio held.

      Positions which have already been matched are not taken into account in calculating the ratios in respect of acquisition-preparing operations.

      As regards so-called multi-tranche operations where the borrower is given the right to claim from the insurance company at fixed dates an increase of the loan amount or the acquisition of further tranches of the loan, only the potential acquisition obligations of the current financial year are taken into account in calculating the ratio.

   3. Yield-enhancing operations

      Yield-enhancing operations occur when the securities actually held in a portfolio are used in order to increase returns via financial derivatives.

      Therefore, only short calls as well as interest rate, currency, and combined interest rate/currency swaps are admissible yield-enhancing operations. The sale of futures contracts does not count as yield-enhancing operations because it is considered to serve hedging purposes. Long calls, the purchase of futures contracts and short puts do not come under yield-enhancing operations because only the existing portfolio may be used for yield-enhancing purposes.

      A maximum of 7.5 per cent of the asset portfolio as at the latest balance-sheet date may be used for yield-enhancing purposes.

4. Combined strategies

   A "combined strategy" is the combination of different types of operation serving a common investment target such as the zero-cost collar (hedging by means of a put which is financed through the sale of a call) or the combination of two interest-rate swaps (changing the term to hedge interest rate risks).

   Only a simple weighting is allowed for measuring the restriction on the volume of combined strategies if the following conditions are met:-

   1. The basic element of a combined strategy is a single basic instrument and it must be possible for any third party to clearly make out that all the other elements are related with this basic instrument (for instance, by forming a valuation unit).
   2. Before conclusion of the contract the combined strategy is broken down into its elements and valued. Both breakdown and valuation are documented. It is also possible to have this breakdown and valuation done by a qualified credit institution with which no derivative operations are carried out. In this case the transfer and specification of the required duties are to be laid down in a services contract.

   3. The combined strategy is clearly designated for one of the following admissible operations, i.e. hedging, acquisition preparation or yield enhancement. The designation has to be made when the contract is concluded.

      Combined strategies are only admissible if their use does not expose the insurance company to greater economic risks than those it would have been exposed to had it used either no financial derivatives or only instruments admissible for hedging, acquisition-preparation and yield-enhancing purposes. In particular, positions with economic effects similar to mere spot transactions cannot be considered to increase the risks.

      Combined strategies which apart from other elements also include short puts (short-put combinations) cannot be classified as yield-enhancing operations. Any additional yield may only be derived from existing securities in accordance with section 7 (2), second sentence, of the VAG.

      Short Put combinations may only be used for hedging or acquisition-preparation purposes. The regulations regarding the use of short puts for acquisition-preparation purposes apply accordingly to the short put included in the combined strategy. Hedging with combined strategies including unmatched short-put positions are excluded because they are unsuitable for hedging purposes.

      If in the case of a combination strategy the requirements under a) and/or c) above are not met the strategy is not admissible unless each of the basic elements is admissible. In this case each individual basic element has to be taken into account for the admissible volume-based restrictions.

5. Index operations

   Options and futures operations are not admissible unless it can be proved that there is an almost complete correlation between the changes in the value of the hedged portfolio of assets and the changes in the securities index. This may be considered to be the case if the structure of the portfolio of assets essentially corresponds with that of the securities index.

   Options and futures operations based on a securities index are admissible as acquisition-preparing operations if the physical delivery of securities underlying the index is agreed that show an almost complete correlation with the movement of the index. If physical delivery is impossible, a cash settlement can be made instead.

   The conclusion of the above-mentioned transactions for acquisition-preparing purposes is also admissible if securities on which the index is based are to be acquired at a later stage by way of an accounting exchange on the assets side. They have to correlate almost entirely with the movements of the securities index. The connection between the transaction of the index operation and the later acquisition of the securities is to be documented in a verifiable manner.

6. Closing out unmatched positions

   If there is a change in the assessment of the market unmatched positions may be matched by relevant counter-operations. An unmatched position is considered to have been closed out if the counter-operation is concluded on the same conditions (exercise price, remaining period, number of contracts). These operations exclusively serving closing out purposes are admissible without restrictions.

   The restrictions on the volume mentioned under A (I.) (3), and (II.) (3) a) to c) above refer to the book value of the portfolio.
   

III. Handling of the operations

Basically, the trading, securities management, risk management and auditing functions shall be linked as smoothly as possible while maintaining a strict separation of their duties. For the individual functions, these duties are generally as follows:-

1. Duties of the trading function

   The trading function is solely responsible for concluding operations within the limits of the decision-making power it is granted by the management. With regard to the types of operation admissible reference is made to A (I) (3) and (II) (3) (above).

   Before each conclusion of an operations the trading function has to take down the prices and volumes of the contracts and examine the extent to which the internally specified trading limits with regard to individual counterparties, products and risk parameters have been met. For the purpose of warehousing each operation concluded must be entered into order forms by the trading function (but not the bookkeeping function) on the day the operation was concluded. The order forms may be designed differently in individual cases. They must, however, contain at least the following information:-

   For options:

   • Internal voucher no.
   • Designation and quantity of the security
   • Date of the operation and signature
   • Counterparty
   • Counterparty limit
   • Volume of the operation in Euro
   • Expiry date
   • Type of operation
   • Option price
   • Exercise price
   • Motive (purpose, list of underlying assets)
   • Other

   
   For futures:

   • Internal voucher no.
   • Designation of the security and quantity
   • Date of the operation and signature
   • Counterparty
   • Counterparty limit
   • Volume of the operation in Euro
   • Period beginning...ending...
   • Type of operation
   • Agreed price
   • Motive (purpose, list of underlying assets)
   • Other

   
   For swaps:

   • Internal voucher no.
   • Type of operation
   • Date of the operation and signature
   • Counterparty
   • Counterparty limit.
   • Basic amount
   • Period beginning...ending...
   • Fixed rate
   • Float rate
   • Motive (purpose, list of underlying assets)
   • Other

   
   The information on concluded and documented operations is to be passed on by the trading function to the securities managment function.

2. Duties of the securities management function

   The securities management function controls the type, scope and result of the operations concluded and handled by the trading function. It examines whether the information given by the trading function is complete, compares it with the written contract confirmations of the counterparty and collects the processed data by means of the portfolio management system of the insurance company (maintaining the "four-eye" principle).

   In this context the securities management function has to establish, in particular, an exact documentation of the purpose of the investment which any expert third party can easily understand (hedging, acquisition-preparation, yield-enhancing purposes) and which clearly shows the links with the main business.

   As regards hedging operations the documentation should contain concrete information about individual assets and the total assets and/or technical provisions and commitments to be hedged.

   As regards acquisition-preparation operations evidence has to be given of the link existing with the envisaged acquisitions. This can be done, for instance, by simply referring to individual data of the insurance company's financial planning or other internal decisions on the acquisition of assets.

   As regards yield-enhancing operations the assets shall be mentioned which are to be used to increase yields.

   Moreover, the securities management function has permanently to control observance of the internal limits. This covers in particular control of the volume-based restrictions in accordance with A (I) (3) and (II) (3) (a) to (c) (above) and control of commercial powers of attorney and powers to sign of company staff.

   Any existing deviations shall be clarified with the trading function immediately and if they are substantial in nature the responsible board member for financial matters or any person so appointed by him shall be notified.

3. Duties of the risk management function

   The inherent risk of operations involving forwards, options and similar financial instruments is in particular linked with the assessment of market trends due to the limited period of these instruments (expiration, exercise, price risk). In addition, as regards OTC operations (in particular swap operations) the solidity of the counterparty has to be taken into account and suitable measures have to be taken to limit the risk of counterparty default.

   To determine the existing market price risk of the company all unmatched positions are to be revalued regularly. The intervals at which these revaluations should reasonably be carried out depend on the type of instrument used and the investment strategy employed. To avoid possible conflicts of interest regular valuations of the overall portfolio must be carried out by a body other than the trading function. Exchange-traded derivatives are marked to market. In cases where a market value cannot be directly determined a theoretical (accounting) value must be used.

   Moreover, to quantify the risk of counterparty default also the duration method authorised by "Principle I concerning the own funds of credit institutions" (see section 10 of the German Banking Law) may be used accordingly.

   All insurance companies using financial derivatives only to a very limited extent are permitted to conclude a risk management agreement with a credit institution which disposes of the relevant technical means. It must be a credit institution other than that which offered the financial derivatives.

   To limit credit risks, counterparty limits have to be established for all counterparties. Examination and documentation of the risks is the duty of risk management.

4. Qualification of staff

   The staff entrusted with the use of the new financial instruments must be adequately qualified. It has to be guaranteed that there is no conflict of interest with the personal transactions of the staff responsible for the use of these financial instruments.

5. Duties of the internal auditing function

   The auditors must be able to judge the adequacy of the internal control procedures. This also includes an examination as to whether the use of financial derivatives in the areas concerned was admissible. Likewise, they have to examine the pre-emptive purchases, derivative products and areas concerned. The internal controls with regard to the notification, measurement and limitation of the risks also have to be examined. If deficiencies are detected in the control system the management has to be notified immediately.

6. Internal guidelines

   To ensure proper management of business affairs it is essential that the company management prescribes adequate internal principles and procedures to carry out the operations described under A (I) and (II) and ensures their being observed and examined regularly. These principles must meet the requirements under A (III) with regard to handling and control of the operations.

7. Information and reporting requirements

   The supervisory board shall be informed before financial derivative operations are carried out for the first time, and where other basic questions in connection with financial derivatives are concerned. Moreover, the supervisory board has to be informed regularly about the scope and economic results of the above operations.

8. Transitional regulation

   Operations which after publication of this circular are not admissible may be terminated in the manner envisaged by the insurance company to avoid economic losses.
   

B. Order concerning the reporting and information requirements within the meaning of section 7 (2), second sentence, of the VAG

In accordance with section 81 (2), first sentence, of the VAG in conjunction with section 7 (2), second sentence, section 54d of the VAG I make the following order:

1. Reports have to be submitted about the scope and results of the operations within the meaning of section 7 (2), second sentence, of the VAG. The notifications in annexes 2 to 7 have to be used for these reports and the explanations in annex 8 to be observed.

   The notifications 1 to 3 have to be deposited with the BAV for reporting purposes for every quarter of a calendar year by the end of the month following such quarter. The notifications 4 to 6 have to be deposited with the BAV annually but not later than four months after the close of the financial year. Negative reports are not required.

2. Copy of the internal principles to be established in accordance with A (III) (6) has to be submitted to the BAV within a period of three months from receipt of this circular. The BAV has to be informed of any changes immediately.

C. Amendment of Circular R 3/99

1. References to circular R 7/95 are replaced by the present circular.

2. A (II) is amended as follows:

   1. The second paragraph of (1) (a) (bb) is deleted.

   2. The following paragraph is added to (3) (b):

      "Internal guidelines have to be established even if only simple structured products are to be acquired. They have to meet the requirements of this circular that are applicable to them in respect of simple structured products."

D. Entry into force, and repeal of circular R7/95

The provisions of this circular are to be applied from January 1, 2001. Circular R 7/95 is repealed.

Information on available legal remedies

Opposition against this order may be lodged in writing with or recorded by the Bundesaufsichtsamt für das Versicherungswesen, 53117 Bonn, Graurheindorfer Strasse 108, within a period of one month from receipt. The opposition shall comprise a specific request, the points of the appeal and the facts and evidence to substantiate the opposition. A decision-taking section inside the BAV will decide on the opposition.

For the BAV:
D. Kaulbach
Vice-President