Insurance Regulatory and Development Authority, or Irda, plans to permit insurers to trade in equity futures and options contracts , which will help the companies protect returns from equity-linked products against sharp stock market declines.

"The rules will be shaped to allow insurers to use equity derivatives for hedging risks only and not for speculating," a senior Irda official told ET on condition of anonymity. The proposal, currently being vetted, will be evaluated by Irda's internal committee on investments soon, the official said. Initially, only unit-linked insurance products, or Ulips, which form over 60% of the local insurance industry's total assets under management of 14.7 lakh crore, will be allowed to trade in equity futures and options, he said. The entire corpus of Ulips can be invested in stocks depending on the mandate.

"Since we manage a large portfolio, equity hedging will help reduce the risk when there is a downside," said Sashi Krishnan, chief investment officer, Bajaj Allianz Life Insurance .

To start with, Irda may cap trading in futures and options by insurance companies at 5% of their assets, said a top official at a state bank-owned insurance company, who did not want to be named. The regulator would raise the limit and give insurers more flexibility to trade once companies are familiar with equity derivative instruments, the official said. Insurers are allowed to use interest rate futures to hedge risks.

Mr Krishnan said several issues, including those related to accounting, need to be addressed before allowing insurers to trade in equity derivatives.

Insurance industry officials expect Irda to follow a roadmap similar to that set out by the Securities and Exchange Board of India, or Sebi, for mutual funds to trade in equity futures and options. In 2002, the securities market regulator permitted mutual funds to use derivatives only to hedge. Three years later, Sebi allowed participation by mutual funds in derivatives on par with foreign investors. The regulator, however, barred mutual funds from selling options last year. Mutual funds have assets worth 6 lakh crore under management.

The move to allow insurance companies to trade in futures and options will boost trading volumes in the equity derivatives market, but only gradually.

"If insurers are allowed to use derivatives, it would only be for prospective schemes. So, insurers would start contributing to the volumes only over a period of time," said Rajesh Baheti, managing director of Mumbai-based Crosseas Capital.

Average daily turnover on the National Stock Exchange's derivatives segment is roughly 1.13 lakh crore in 2010-11, as against 72,000 crore in 2009-10.

Leading brokers, whose derivatives business have been impacted after Sebi barred mutual funds from selling options, have been nudging insurance companies to push Irda to allow them to participate in the equity derivatives market.

ET