The Office of the Superintendent of Financial Institutions has published a draft advisory that gives insurance companies guidance on the recognition of hedges in terms of their segregated fund capital requirements.

In the advisory, OSFI notes that it encourages companies with material segregated fund guarantee risk exposure to develop and implement plans for managing this risk, and that hedge contracts are one way of doing this. Explicit approval from OSFI is required before a company may recognize any hedge contracts in determining its segregated fund guarantee regulatory capital requirement.

The notice says that the amount of recognition that a company’s hedge contracts receive will be determined at the time of approval and will depend in part on: the derivative or financial instruments used to implement the hedge and their relationship to the underlying segregated fund guarantee risk; the residual risks that are not hedged; the demonstrated effectiveness of the hedge contracts; new risks introduced as a result of the hedge contracts; and, the effectiveness of the company’s overall risk management infrastructure.

Over-the-counter hedge contracts will remain subject to the charges for counterparty credit risk.

It also says that the only hedge contracts that will be considered for recognition in the determination of a company’s segregated fund guarantee regulatory capital requirement are the hedge contracts that the company holds as of the valuation date. While companies may wish to implement forward-looking strategies that involve the anticipated use of hedge contracts, for their own internal risk management purposes, contracts that the company has not yet entered into as of the valuation date will not be recognized in the determination of the company’s segregated fund guarantee regulatory capital requirement.

Comments are invited by June 20. The notice adds that updated guidance on the requirements that a company must meet to be eligible for approval, and information on the application procedure, will be provided in a subsequent notice.