Some directors, frightened by derivatives horror stories, have been tempted to categorically forbid the use of any and all derivatives for whatever purpose. Although this is not necessarily an incorrect decision, directors may be exposing themselves to significant legal risks if they unilaterally ban derivatives without doing an assessment of the risks the ban would expose them to.
In one landmark case Compaq Computer Corporation was sued by its shareholders for not disclosing that it did not hedge the firm's exposure to currency risk, though 54 percent of the firm's revenue came from overseas. Moreover, in Brane v. Roth, an Indiana state appellate court held the board members of a grain cooperative personally liable to shareholders for losses due to an untrained and unsupervised manager's failure to implement the board's hedging authorizations.
A derivative is a financial asset or liability whose value depends on (or is derived from) other assets, liabilities or indexes (the "underlying asset"). Derivatives are financial contracts and include a wide assortment of instruments, such as forwards, futures, options, warrants, swaps and composites. This standard also applies to structured products that have the effect of derivatives and could apply to commodity derivatives, where insurers are permitted to engage in these transactions (Narayanan, 39-59).
Derivative products have inherent risks that must be managed properly. As with traditional investment activities, insurance companies must address credit, market, liquidity, cashflow, operational and legal risks in their derivatives activities. The nature and the degree of these risks will depend on how derivatives are used. The growing complexity, diversity and volume of derivatives products, made possible by academic research and rapid advances in technology and communications, pose increasing challenges in managing these risks.
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