Section 806.40  Guidelines and Internal Control Procedures

a)         Before engaging in a derivative transaction, an insurer shall establish written guidelines that shall be used for effecting and maintaining the transactions.  The guidelines shall:

1)         Address investment or, if applicable, underwriting objectives, and risk constraints, such as credit risk limits;

2)         Address permissible transactions and the relationship of those transactions to its operations, such as a precise identification of the risks being hedged by a derivative transaction; and

3)         Require compliance with internal control procedures.

b)         An insurer shall have a system for determining whether a derivative instrument used for hedging has been effective.  In so doing a company should set specific criteria at the inception of the hedge as to what will be considered "effective" in measuring the hedge and then apply those criteria in the ongoing assessment based on actual hedge results.

c)         An insurer shall have a credit risk management system for over-the-counter derivative transactions that measures credit risk exposure using the counterparty exposure amount.

d)         An insurer's board of directors shall, in accordance with Section 126.4 of the Illinois Insurance Code [215 ILCS 5/126.4]:

1)         Approve the guidelines required by subsection (a) of this Section and the systems required by subsections (b) and (c) of this Section; and

2)         Determine whether the insurer has adequate professional personnel, technical expertise and systems to implement investment practices involving derivatives.

e)         An insurer may used derivatives for replication transactions as permitted pursuant to Sections 126.18 and 126.31 of the Illinois Insurance Code [215 ILCS 5/126.18 and 126.31].  An insurer engaging in replication transactions shall:

1)         Comply with the following requirements:

A)        The disclosure and annual and quarterly statement reporting of such replication transactions;

B)        The inclusion of such transaction in the insurer's Risk Based Capital Report (as required by Section 35A-10 of the Illinois Insurance Code [215 ILCS 5/35A-10]); and

C)        If applicable, the calculation and reporting of the asset valuation reserve for such transaction;

2)         Comply with the filing requirements for Replication Synthetic Asset Transactions (RSATs) contained in the Purposes and Procedures Manual of the Securities Valuation Office of the National Association of Insurance Commissioners (Volume-Issue 99-2, July 2000, no subsequent dates or editions);

3)         File with the Director of Insurance a duplicate copy of all RSAT filings made with the Securities Valuation Office of the National Association of Insurance Commissioners; after June 1, 2002, the Director may waive this duplicate filing requirement;

4)         Have a system for determining whether a replication transaction has been effective in replicating the intended investment position; and

5)         Include all replicated investment positions in calculating compliance with the limitations on investments contained in Article VIII of the Illinois Insurance Code [215 ILCS 5/Art. VIII]; provided, that no replicated investment position shall be held pursuant to the additional investment authority contained in Sections 126.20 and 126.32 of the Illinois Insurance Code [215 ILCS 5/126.20 and 126.32].

            AGENCY NOTE:  For purposes of determining whether internal control procedures are in compliance with this Part, the Department may consider, but is not limited to, the following items:  that only board authorized individuals can effect derivative instrument transactions, that there is a separation of administrative functions from trading functions, that periodic reporting to chief investment officer of open positions occurs and that periodic assessing of effectiveness of hedging transaction be conducted by a designated person.

(Source:  Amended at 25 Ill. Reg. 4578, effective March 15, 2001)