20-560. Derivative transactions; definitions

A. An insurer, directly or indirectly through an investment subsidiary, may use derivative instruments to engage in hedging transactions, income generation transactions and replication transactions pursuant to this section.

B. An insurer may enter into hedging transactions if, after giving effect to such transactions, all of the following apply:

1. The aggregate statement value of options, caps, floors and warrants not attached to another financial instrument purchased and used in hedging transactions does not exceed seven and one-half per cent of its admitted assets.

2. The aggregate statement value of options, caps and floors written in hedging transactions does not exceed three per cent of its admitted assets.

3. The aggregate potential exposure of collars, swaps, forwards and futures used in hedging transactions does not exceed six and one-half per cent of its admitted assets.

C. An insurer may enter into the following types of income generation transactions if after giving effect to the transactions 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, does not exceed ten per cent of its admitted assets:

1. Sales of covered call options on noncallable fixed income securities, callable fixed income securities if the option expires by its terms before the end of the noncallable period or derivative instruments based on fixed income securities.

2. Sales of covered call options on equity securities, if the insurer 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.

3. Sales of covered puts on investments that the insurer is permitted to acquire under this article, if the insurer 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.

4. Sales of covered caps or floors, if the insurer 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.

D. An insurer may enter into replication transactions with the prior written approval of the director if both of the following apply:

1. The insurer would otherwise be authorized to invest its funds under this article in the asset being replicated.

2. The asset being replicated is subject to all the provisions of this article relating to the making of investments by the insurer in that type of asset as if the transaction constituted a direct investment by the insurer in the replicated asset.

E. The director may approve of additional transactions involving the use of derivative instruments in excess of the limits of subsection B of this section or for other risk management purposes, except that replication transactions shall be permitted only for risk management purposes.

F. Each derivative instrument shall be one of the following:

1. Traded on a qualified exchange.

2. Entered into with or guaranteed by a business entity.

3. Issued or written with the issuer of the underlying interest on which the derivative instrument is based.

4. Entered into with a qualified foreign exchange.

G. For the purposes of this section, unless the context otherwise requires:

1. "Business entity" includes a sole proprietorship, corporation, limited liability company, association, partnership, joint stock company, joint venture, mutual fund, trust, joint tenancy or other similar form of business organization, whether organized for-profit or not-for-profit.

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

3. "Collar" means 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. "Derivative instrument":

(a) Means an agreement, option or instrument or a series or combination that either:

(i) Requires a party to make or take delivery of, or assume or relinquish, a specified amount of one or more underlying interests, or to make a cash settlement in lieu thereof.

(ii) Has a price, performance, value or cash flow based primarily on the actual or expected price, level, performance, value or cash flow of one or more underlying interests.

(b) Includes 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 or any series or combination thereof and any agreements, options or instruments permitted under rules adopted to carry out the provisions of this article.

(c) Does not include an investment authorized by sections 20-537 through 20-548, 20-550 through 20-558, 20-561 and 20-562.

5. "Derivative transaction" means a transaction involving the use of one or more derivative instruments.

6. "Floor" means 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 exceeds a reference price, level, performance or value of one or more underlying interests.

7. "Forward" means 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.

8. "Future" means an agreement, traded on a qualified exchange or qualified foreign 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.

9. "Hedging transaction" means a derivative transaction that is entered into and maintained to reduce either:

(a) The risk of a change in the value, yield, price, cash flow or quantity of assets or liabilities that the insurer 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 an insurer has acquired or incurred or anticipates acquiring or incurring.

10. "Income generation transaction" means 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.

11. "Option" means an agreement giving the buyer the right to buy or receive, referred to as a "call option", to sell or deliver, referred to as a "put option", to enter into, extend or terminate, or to effect a cash settlement based on the actual or expected price, spread, level, performance or value of one or more underlying interests.

12. "Qualified exchange" means:

(a) A securities exchange registered as a national securities exchange, or a securities market regulated under the securities exchange act of 1934, as amended.

(b) A board of trade or commodities exchange designated as a contract market by the commodity futures trading commission or any successor thereof.

(c) Private offerings, resales and trading through automated linkages.

(d) A designated offshore securities market as defined in securities exchange commission regulations, 17 Code of Federal Regulations part 230, as amended.

(e) A qualified foreign exchange.

13. "Qualified foreign exchange" means a foreign exchange, board of trade or contract market located outside the United States or its territories or possessions if one of the following applies:

(a) The exchange, board of trade or contract market has received regulatory comparability relief under commodity futures trading commission rule 30.10, as set forth in appendix C to 17 Code of Federal Regulations part 30.

(b) The exchange, board of trade or contract market is, or its members are, subject to the jurisdiction of a foreign futures authority that has received regulatory comparability relief under commodity futures trading commission rule 30.10, as set forth in appendix C to 17 Code of Federal Regulations, part 30, as to futures transactions in the jurisdiction where the exchange, board of trade or contract market is located.

(c) Foreign stock index futures contracts are listed on the exchange, board of trade or contract market and the contracts are the subject of no-action relief issued by the commodity futures trading commission office of general counsel if the exchange, board of trade or contract market that qualifies as a qualified foreign exchange under this subdivision is a qualified foreign exchange only as to foreign stock index futures contracts that are the subject of no-action relief.

14. "Replication transaction":

(a) Means a derivative transaction that is intended to replicate the performance of one or more assets that an insurer is authorized to acquire under this article.

(b) Does not include a derivative transaction that is entered into as a hedging transaction.

15. "Swap" means 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.

16. "Underlying interest" means the assets, liabilities, other interests or a combination thereof underlying a derivative instrument, including any securities, currencies, rates, indices, commodities or derivative instruments.

17. "Warrant" means 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.  Warrants may be issued alone or in connection with the sale of other securities, including as part of a merger or recapitalization agreement or to facilitate divestiture of the securities of another business entity.