WASHINGTON -- Insurance companies would not be allowed to invest in derivatives for speculative purposes under proposed investment standards issued yesterday by the National Association of Insurance Commissioners.

The proposed standards, which were developed over a three-year period, are designed to ensure that insurance company investments are sound so that policyholder claims are paid on a timely basis and shareholders obtain returns, association sources said.

The draft standards are still subject to public comment and possible revision. They would have to be adopted by the association and the states to become effective for insurance companies, the sources said.

The association, which represents state regulators, could require state insurance commissions to adopt the standards in order to receive accreditation, said one source who did not want to be identified. But no decision has been made in this regard, he said.

Meanwhile, the association plans to hold a public hearing on the proposed standards on Sept. 21 in Minneapolis in conjunction with its fall meeting.

Under the proposed investment standards, insurance companies could only use derivatives for hedging and for certain limited "income generation transactions" such as selling covered call options on specific kinds of securities or derivative instruments.

The use of derivatives for speculation would be prohibited.

An insurer's board of directors would have to adopt a written plan for acquiring and holding investments, including investments in derivatives. The board would have to review the insurer's portfolio on a quarterly basis and insure that its investments meet the criteria in the plan.

Insurers would have to be able to demonstrate the effectiveness of their derivatives transactions for state commissioners through cash-flow testing or some other analysis.

The proposed standards would place limits on an insurer's investments in derivatives for hedging purposes.

For example, the "aggregate statement value" or replacement value of options, caps, and floors written in hedging transactions could not exceed 3% of the insurer's "admitted assets." These are the general assets that an insurer is required to include in the financial statement submitted to its state insurance commission, association sources said.

The replacement value of options, caps, floors, and warrants not attached to any other financial instrument purchased in a hedging transaction could not exceed 7.5% of such assets.

The aggregate potential exposure of collars, swaps, forwards, and futures used in hedging transactions could not exceed 5% of such assets.

Insurers would be limited to two general kinds of "income generation transactions," under the draft standards.

An insurer could sell covered call options on noncallable fixed-income securities or derivative instruments based on fixed-income securities, as long as the replacement value of the assets subject to call during the term of the call options sold plus the face value of the fixed-income securities underlying any derivative instrument subject to call does not exceed 10% of the insurer's admitted assets.

An insurer could also sell covered call options on equity securities as long as it holds the equity securities subject to call in its portfolio during the term of the call options sold.

The proposed standards would also limit an insurer's exposure to any one counterparty in derivatives transactions to 1% of the insurer's "admitted assets."

The draft standards are part of a two-pronged effort by state regulators to improve their oversight of insurance company investments in derivatives, association sources said.

The association also recently adopted new disclosure requirements to improve insurers' disclosures about their derivatives investments in their annual financial statements, the sources said.

The requirements take effect for 1994 financial statements and call for insurers to disclose all of their derivative transactions during the year, not just those still open at the end of the year, the sources said.

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