Indian Insurers Seek Greater Flexibility to Use Equity Derivatives for Portfolio Hedging

Indian Insurers Seek Greater Flexibility to Use Equity Derivatives for Portfolio Hedging

Indian insurance companies are seeking greater regulatory flexibility in using equity derivatives to protect their investment portfolios, including permission to aggregate derivative exposure across multiple funds instead of applying hedging limits separately to every individual fund.

The request comes more than a year after the Insurance Regulatory and Development Authority of India permitted insurers to use exchange-traded equity derivatives exclusively for hedging existing equity exposures in February 2025.

Despite the regulatory opening, actual adoption has remained extremely limited.

Only:

one life insurer

has reportedly used equity derivatives so far, and even that activity has been restricted to only:

one or two transactions.

The industry's limited adoption suggests that the existing framework, while providing insurers with access to derivatives, may be too restrictive for large institutions managing numerous portfolios and segregated funds.

Insurers are therefore seeking a framework that would make derivatives more practical for:

long-term portfolio management,

market-risk reduction,

and protection against significant equity-market declines.

The regulator, meanwhile, must balance greater flexibility with safeguards ensuring derivatives remain a:

risk-management tool rather than a source of speculative leverage.

Insurers Want Derivative Limits Aggregated Across Funds

One of the industry's central requests concerns how derivative exposure is calculated.

Under the existing framework, derivative positions are linked to the equity holdings of:

individual funds or sub-funds.

Insurers want greater flexibility to aggregate those positions across:

multiple funds.

This could allow an insurance company to manage equity risk more efficiently at the broader portfolio level rather than establishing separate hedging positions for each individual investment pool.

The distinction matters particularly for large life insurers.

A single insurer can manage numerous:

ULIP funds,

life funds,

pension portfolios,

annuity funds,

group insurance funds,

and other investment pools.

Applying hedging restrictions independently to every fund can make portfolio-level risk management operationally complicated.

IRDAI Allowed Equity Derivatives in February 2025

IRDAI introduced its Guidelines on Hedging through Equity Derivatives on:

February 28, 2025.

The regulator's objective was to allow insurers to protect equity portfolios from:

market volatility,

declines in investment values,

and broader equity-market risk.

Before this framework, insurers had considerably less flexibility to use equity derivatives as part of their investment-risk management.

The decision reflected the growing scale of equity investments held by India's insurance industry.

As insurers accumulate larger stock portfolios, their balance sheets become more exposed to sudden changes in:

equity valuations.

Derivatives can provide a mechanism for reducing that risk without forcing insurers to sell long-term investments.

Derivatives Can Only Be Used for Hedging

A crucial feature of IRDAI's framework is that insurers can't use equity derivatives simply to make leveraged market bets.

The instruments can be used:

only for hedging purposes.

The insurer must already hold the underlying equity exposure before establishing the corresponding derivative hedge.

This creates a fundamental distinction between:

hedging

and:

speculation.

A hedge is designed to reduce an existing financial risk.

Speculation creates or increases exposure in an attempt to profit from future market movements.

IRDAI's rules are specifically structured around the first objective.

Insurers Can Use Futures and Put Options

The regulatory framework permits insurers to use specified:

exchange-traded equity derivatives.

These include:

stock futures,

index futures,

stock options,

and index options.

For futures, insurers can establish:

short positions

against existing equity holdings.

For options, insurers are permitted to act as option buyers and purchase:

put options

against underlying equity exposure.

These instruments can help offset losses if equity markets decline.

How a Futures Hedge Works

Consider an insurer holding a substantial portfolio of stocks that broadly tracks a major equity index.

The insurer expects to hold those shares for the long term.

However, it may become concerned about:

short-term market volatility.

Selling the underlying stocks could be undesirable because doing so might:

disrupt the portfolio,

generate transaction costs,

or conflict with long-term investment objectives.

Instead, the insurer could sell:

index futures.

If the equity market subsequently declines, losses in the stock portfolio could be partially offset by gains on the short futures position.

When the risk period ends, the insurer can close the hedge while continuing to own its long-term equity investments.

Put Options Provide Downside Protection

Put options provide another method of protecting a portfolio.

A put option gives its holder the right to benefit from declines below specified price levels.

An insurer can therefore purchase put options against:

stocks

or:

equity indices

represented within its investment portfolio.

The insurer pays a:

premium

for this protection.

If markets rise, the option may expire without being exercised, and the insurer retains the gains from its underlying equity portfolio while losing the premium paid for protection.

If markets fall sharply, the put option can increase in value and offset part of the portfolio decline.

This resembles purchasing insurance against:

market losses.

Current Rules Require Hedging Within the Same Fund

The existing guidelines impose an important operational constraint.

Short futures positions must generally be taken within:

the same fund

where the underlying equities are held.

Similarly, put options must be purchased within the fund containing the corresponding equity exposure.

This structure ensures a close relationship between:

the hedge

and:

the underlying asset.

From a regulatory perspective, that makes it easier to demonstrate that derivatives are genuinely being used to reduce risk.

For insurers, however, the same requirement can make hedging less efficient when portfolios are spread across numerous segregated funds.

Derivative Exposure Can't Exceed Underlying Equity Holdings

IRDAI also limits the total derivative exposure within each fund.

At notional value, combined positions across:

stock futures,

index futures,

stock options,

and index options

can't exceed the market value of the underlying equities held within that fund.

The rule is designed to prevent:

over-hedging and speculative leverage.

If an insurer owns ₹1,000 crore of equities within a particular fund, the regulatory framework is designed to prevent it from establishing a derivative position substantially exceeding the underlying exposure.

Passive breaches resulting from market movements must generally be corrected within the prescribed period.

Insurers Want Portfolio-Level Risk Management

The industry's requested change reflects how large institutional portfolios are actually managed.

A major insurer may have broadly similar equity exposures distributed across many investment funds.

Each fund could own shares in:

banks,

technology companies,

consumer businesses,

industrial companies,

and major index constituents.

The insurer's overall exposure may therefore be highly correlated across different funds.

From an enterprise risk-management perspective, management may view this as:

one broad equity-market risk.

The current regulatory framework, however, requires the hedging calculation to remain much more closely connected to individual funds.

Allowing some aggregation could potentially make portfolio protection:

simpler,

cheaper,

and more efficient.

Adoption Has Remained Extremely Limited

More than a year after IRDAI permitted equity derivatives, insurers have barely used them.

Only one life insurer has reportedly executed derivatives transactions under the framework so far.

Even there, activity has been limited to:

one or two deals.

This is notable because insurers collectively manage enormous investment portfolios and therefore have substantial theoretical demand for risk-management instruments.

The limited usage indicates that regulatory permission alone doesn't automatically create practical adoption.

Insurers also need:

operational systems,

risk models,

governance frameworks,

accounting procedures,

and investment flexibility

before derivatives can become a routine portfolio-management tool.

Insurers Initially Focused on Building Risk Systems

Insurance companies have spent time developing the infrastructure needed to use derivatives safely.

This includes:

risk-management frameworks,

treasury systems,

technology upgrades,

valuation processes,

reporting mechanisms,

and internal controls.

Derivatives introduce risks beyond simply predicting whether the market will rise or fall.

Companies must manage:

basis risk,

liquidity risk,

rollover risk,

execution risk,

operational risk,

and counterparty-related processes.

Even exchange-traded derivatives therefore require substantial institutional infrastructure.

Board-Approved Hedging Policies Are Required

IRDAI's framework places significant governance responsibilities on insurers.

Before using equity derivatives, an insurer must have:

a board-approved hedging policy.

Senior management and the board must understand the:

nature of the risks,

complexity of the instruments,

potential stress scenarios,

and systems required to manage derivative positions.

This requirement reflects the fact that derivatives can become dangerous when institutions use them without adequate controls.

The objective is to ensure that derivatives remain integrated into:

formal risk management

rather than becoming isolated trading activities.

Risk Committees Must Monitor Derivative Exposure

Insurers must also report their derivative positions and compliance with exposure limits to their:

Risk Management Committee

at least quarterly.

The board must periodically review the derivatives activity and determine whether adequate:

risk measurement,

policies,

procedures,

and controls

remain in place.

These requirements create multiple layers of oversight.

For policyholders, this is important because insurance-company investment portfolios ultimately support:

long-term financial obligations.

Investment risk therefore has direct implications for insurers' ability to meet future claims and policy commitments.

IRDAI Must Be Informed Before First Derivative Exposure

An insurer planning to use equity derivatives must also inform IRDAI before taking exposure for the first time.

Once activity begins, insurers have continuing reporting requirements.

They must provide information covering areas such as:

hedging positions,

derivative turnover,

stock futures,

put options,

position unwinding,

and realised profits or losses.

This reporting gives the regulator greater visibility into how the industry is using the instruments.

It can also help IRDAI identify whether derivatives are reducing risk as intended or creating unexpected concentrations.

OTC Equity Derivatives Remain Prohibited

The framework doesn't permit insurers unrestricted access to every form of equity derivative.

Over-the-counter equity derivatives are prohibited.

Insurers must use eligible exchange-traded instruments.

Exchange-traded derivatives generally offer stronger standardisation and transparency around:

contracts,

pricing,

margining,

and settlement.

Central clearing can also reduce certain counterparty risks compared with privately negotiated bilateral contracts.

Restricting insurers to exchange-traded products therefore provides another layer of regulatory protection.

ULIPs Could Be Major Users of Hedging Tools

Unit-linked insurance plans are one area where derivatives could potentially become particularly relevant.

ULIPs can hold significant allocations to:

equities.

The value of those portfolios therefore moves with financial markets.

During periods of severe volatility, hedging could potentially help insurers manage downside risk within applicable fund mandates.

Life insurers had ULIP funds totalling approximately:

₹7.6 lakh crore in FY24.

The scale demonstrates why even limited use of derivatives by the insurance sector could eventually represent significant activity in India's institutional derivatives market.

General and Health Insurers Can Also Hedge

The framework isn't limited exclusively to life insurers.

Eligible investment assets of:

general insurers

and:

health insurers

can also use equity derivatives subject to the regulatory conditions.

However, the relative importance of equity hedging differs across insurers because investment portfolios vary substantially according to:

liability structure,

product design,

duration,

liquidity requirements,

and regulatory asset allocation.

Life insurers, with their large long-term investment pools, are particularly important participants in India's capital markets.

Hedging Can Reduce Forced Selling During Market Stress

One potential advantage of derivatives is their ability to reduce the need for:

forced portfolio sales.

Suppose an insurer believes equity markets face significant short-term downside risk.

Without derivatives, reducing exposure might require selling:

physical shares.

If markets subsequently recover, rebuilding those positions could be expensive and operationally inefficient.

A derivatives hedge allows the insurer to temporarily reduce its net market exposure while retaining ownership of the underlying securities.

This can be especially useful for:

long-duration institutional investors.

Derivatives Don't Eliminate Investment Risk

Hedging isn't a guarantee against losses.

A derivatives position may not perfectly match the underlying portfolio.

This creates:

basis risk.

For example, an insurer could hedge a diversified portfolio using index futures.

If the stocks held by the insurer perform differently from the index, the hedge won't perfectly offset losses.

Options also have costs.

Buying downside protection requires paying:

option premiums.

Repeatedly purchasing protection can reduce investment returns if the expected market decline doesn't occur.

The purpose of hedging is therefore:

risk reduction,

not risk elimination.

More Flexibility Could Lower Hedging Costs

Aggregating exposure across funds could potentially make hedging more efficient.

Instead of maintaining numerous smaller derivative positions against separate portfolios, an insurer might be able to construct:

larger,

more liquid,

portfolio-level hedges.

This could reduce:

transaction complexity,

operational workload,

and potentially execution costs.

Larger index-based hedges may also be easier to manage than numerous individual positions.

However, aggregation introduces another regulatory question:

how should gains, losses and risks from the hedge be allocated among different policyholder funds?

That issue is likely to be important when evaluating any relaxation.

Policyholder Protection Remains the Regulatory Priority

IRDAI's cautious approach reflects the unique nature of insurance investment management.

An insurer isn't investing only shareholder capital.

Much of the money under management ultimately supports obligations to:

policyholders.

That means the regulator must ensure that any expanded derivatives activity doesn't expose policyholder assets to:

excessive leverage,

speculative positions,

or poorly controlled trading strategies.

Greater flexibility may therefore require additional safeguards.

These could potentially involve:

stronger reporting,

exposure monitoring,

risk attribution,

governance,

or technology controls.

Equity Exposure Has Become Increasingly Important for Insurers

The debate is occurring as insurers become increasingly significant institutional investors in Indian equities.

Premiums collected from policyholders are invested across assets including:

government securities,

corporate bonds,

equities,

and other permitted instruments.

Equities can provide important long-term growth, but they also introduce:

market volatility.

As insurance portfolios expand, even relatively small percentage movements in equity markets can translate into large changes in portfolio values.

More sophisticated risk-management tools therefore become increasingly relevant.

Volatile Markets Strengthen the Case for Hedging

The value of hedging becomes particularly visible during periods of:

sharp market corrections,

geopolitical shocks,

commodity-price spikes,

interest-rate uncertainty,

or global financial stress.

Long-term institutional investors may not want to abandon equity exposure simply because markets become temporarily volatile.

Derivatives can potentially provide a middle path.

They allow institutions to retain strategic investments while temporarily reducing some downside exposure.

For insurers managing liabilities extending decades into the future, that flexibility can be valuable.

Wider Insurer Participation Could Affect India's Derivatives Market

If IRDAI eventually allows greater flexibility and insurers begin using derivatives at scale, the impact could extend beyond insurance portfolios.

Large insurers manage substantial pools of capital.

Their increased participation could contribute to additional institutional demand for:

index futures,

stock futures,

and put options.

This could influence:

market liquidity,

institutional hedging activity,

and the structure of India's derivatives ecosystem.

However, insurers would remain fundamentally different from speculative derivatives traders because regulatory rules restrict their activity to:

hedging existing exposures.

IRDAI Faces a Balance Between Flexibility and Control

The industry's request creates a familiar regulatory challenge.

Rules that are too restrictive can make legitimate risk-management tools impractical.

Rules that are too permissive can create:

leverage,

complexity,

and systemic risk.

IRDAI therefore needs to find a framework that allows insurers to hedge portfolios efficiently while maintaining a clear relationship between:

derivative exposure

and:

underlying assets.

The extremely limited adoption under the existing framework provides a reason to reconsider whether current restrictions achieve the optimal balance.

Conclusion

Indian insurers are seeking greater flexibility in the use of equity derivatives for portfolio hedging, particularly by allowing derivative exposure to be aggregated across multiple funds rather than applying limits independently to each fund.

IRDAI first permitted insurers to use equity derivatives in February 2025, allowing short positions in eligible futures and purchases of put options against existing equity holdings.

However, adoption has remained extremely limited, with only one life insurer reportedly using the framework so far and executing only one or two transactions.

The industry's request reflects a practical challenge: large insurers manage numerous segregated portfolios, while equity-market risk can often be more efficiently assessed and managed across the broader investment book.

Greater flexibility could make hedging more effective, but it would also require safeguards ensuring that derivatives remain instruments for risk reduction rather than speculative leverage.

As insurers' equity portfolios grow, the eventual regulatory balance could become increasingly important for both policyholder protection and institutional risk management in India's capital markets.