(a) As used in this section: (1) "Cap" means an agreement obligating the seller to make payments to the buyer with each payment based on the amount by which a reference price or level or the performance or value of one (1) or more underlying interests exceeds a predetermined number, sometimes called the strike rate or strike price; (2) "Collar" means an agreement to receive payments as the buyer of an option, cap, or floor and to make payments as the seller of a different option, cap, or floor; (3) (A) "Counterparty exposure amount" means the net amount of credit risk attributable to an over-the-counter derivative instrument. The amount of credit risk equals: (i) The market value of the over-the-counter derivative instrument if the liquidation of the derivative instrument would result in a final cash payment to the insurer; or (ii) Zero (0) if the liquidation of the derivative instrument would not result in a final cash payment to the insurer. (B) If over-the-counter derivative instruments are entered into under a written master agreement which provides for netting of payments owed by the respective parties and the domiciliary jurisdiction of the counterparty is either within the United States or if not within the United States, within a foreign jurisdiction listed in the National Association of Insurance Commissioners' publication prepared by its Securities Valuation Office as it existed on January 1, 2005, entitled the "Purposes and Procedures Manual" as eligible for netting, the net amount of credit risk shall be the greater of zero (0) or the net sum of: (i) The market value of the over-the-counter derivative instruments entered into under the agreement, the liquidation of which would result in a final cash payment to the insurer; and (ii) The market value of the over-the-counter derivative instruments entered into under the agreement, the liquidation of which would result in a final cash payment by the insurer to the business entity. (C) For open transactions, market value shall be determined at the end of the most recent quarter of the insurer's fiscal year and shall be reduced by the market value of acceptable collateral held by the insurer or placed in escrow by one (1) or both parties; (4) "Covered" means that an insurer: (A) Owns or can immediately acquire through the exercise of options, warrants, or conversion rights already owned the underlying interest in order to fulfill or secure its obligations under a call option, cap, or floor it has written; or (B) Has set aside under a custodial or escrow agreement, cash or cash equivalents with a market value equal to the amount required to fulfill its obligations under a put option it has written in an income generation transaction; (5) (A) "Derivative instrument" means an agreement, option, instrument, or a series or combination thereof: (i) To make or take delivery or assume or relinquish a specified amount of one (1) or more underlying interests or to make a cash settlement in lieu thereof; or (ii) That has a price, performance, value, or cash flow based primarily upon the actual or expected price, level, performance, value, or cash flow of one (1) or more underlying interests. (B) "Derivative instrument" includes options, warrants used in a hedging transaction and not attached to another financial instrument, caps, floors, collars, swaps, forwards, futures, and any other agreements, options, or instruments substantially similar thereto or any series or combination thereof and any agreements, options, or instruments permitted under regulations adopted by the Insurance Commissioner. (C) "Derivative instrument" does not include an investment authorized by any other provision of this subchapter; (6) "Derivative transaction" means a transaction involving the use of one (1) or more derivative instruments; (7) "Direct" or "directly", when used in connection with an obligation, means that the designated obligor is primarily liable on the instrument representing the obligation; (8) "Floor" means an agreement obligating the seller to make payments to the buyer in which each payment is based on the amount by which a predetermined number, sometimes called the floor rate or price, exceeds a reference price, level, performance, or value of one (1) or more underlying interests; (9) "Forward" means an agreement other than a future to make or take delivery or effect a cash settlement based on the actual or expected price, level, performance, or value of one (1) or more underlying interests; (10) "Future" means an agreement traded on a qualified exchange or qualified foreign exchange to make or take delivery or effect a cash settlement based on the actual or expected price, level, performance, or value of one (1) or more underlying interests; (11) "Hedging transaction" means a derivative transaction which is entered into and maintained to reduce: (A) The risk of a change in the value, yield, price, cash flow, or quantity of assets or liabilities that the insurer has acquired or incurred or anticipates acquiring or incurring; or (B) The currency exchange rate risk or the degree of exposure of assets or liabilities that an insurer has acquired or incurred or anticipates acquiring or incurring; (12) "Income" means, with respect to a security, any interest, accrual of discount, dividends, or other distributions, such as rights, tax or assessment credits, warrants, and distributions in kind; (13) "Income generation transaction" means a derivative transaction involving the writing of covered call options, covered put options, covered caps, or covered floors that is intended to generate income or enhance return; (14) "Option" means an agreement giving the buyer the right to buy or receive, that is, a "call option", sell or deliver, that is, a "put option", enter into, extend, or terminate or effect a cash settlement based on the actual or expected price, level, performance, or value of one (1) or more underlying interests; (15) "Over-the-counter derivative instrument" means a derivative instrument entered into with a business entity other than through a qualified exchange, qualified foreign exchange, or cleared through a qualified clearinghouse; (16) "Potential exposure" means the amount determined in accordance with the National Association of Insurance Commissioners' Annual Statement Instructions in effect on January 1, 2005; (17) (A) "Replication transaction" means a derivative transaction that is intended to replicate the performance of one (1) or more assets that an insurer is authorized to acquire under Arkansas law. (B) A derivative transaction entered into as a hedging transaction is not considered a replication transaction; (18) "Swap" means an agreement to exchange or to net payments at one (1) or more times based on the actual or expected price, level, performance, or value of one (1) or more underlying interests; (19) "Underlying interest" means the assets, liabilities, other interests, or a combination thereof, underlying a derivative instrument, such as any one (1) or more securities, currencies, rates, indices, commodities, or derivative instruments; and (20) (A) "Warrant" means an instrument that gives the holder the right to purchase an underlying financial instrument at a given price and time or at a series of prices and times outlined in the warrant agreement. (B) Warrants may be issued alone or in connection with the sale of other securities, for example, as part of a merger or recapitalization agreement or to facilitate divestiture of the securities of another business entity. (b) (1) An insurer may use derivative instruments under this section to engage in: (A) Hedging transactions; and (B) Certain income generation transactions if the commissioner does not object to the proposed derivative transaction plan submitted by the insurer. (2) An insurer shall be able to demonstrate to the commissioner the intended hedging characteristics and the ongoing effectiveness of the derivative transaction or combination of the transactions through cash flow testing or other appropriate analyses. (3) (A) Before engaging in derivative transactions, an insurer shall establish written guidelines that shall be used for effecting and maintaining the transactions. (B) The guidelines shall: (i) Address investment or, if applicable, underwriting objectives and risk constraints, such as credit risk limits; (ii) 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 (iii) Require compliance with internal control procedures. (4) An insurer shall have a system for determining whether a derivative instrument used for hedging has been effective. (5) 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. (6) An insurer's board of directors shall approve the guidelines required by this subsection and determine whether the insurer has adequate professional personnel, technical expertise, and systems to implement investment practices involving derivatives. (c) An insurer may enter into hedging transactions under this section if as a result of and after giving effect to the transaction: (1) The aggregate statement value of options, caps, floors, and warrants not attached to another financial instrument purchased and used in hedging transactions does not exceed seven and one-half percent (7.5%) of its admitted assets; (2) The aggregate statement value of options, caps, and floors written in hedging transactions does not exceed three percent (3%) of its admitted assets; and (3) The aggregate potential exposure of collars, swaps, forwards, and futures used in hedging transactions does not exceed six and one-half percent (6.5%) of its admitted assets. (d) An insurer may enter only into the following types of income generation transactions if as a result of and after giving effect to the transactions the aggregate statement value of the fixed income assets that are subject to call or, for life and health insurers, that generate the cash flows for payments under the caps or floors, plus the face value of fixed income securities underlying a derivative instrument subject to call, plus the amount of the purchase obligations under the puts, does not exceed ten percent (10%) of its admitted assets: (1) Sales of covered call options on noncallable fixed income securities, callable fixed income securities if the option expires by its terms prior to the end of the noncallable period, or derivative instruments based on fixed income securities; (2) Sales of covered call options on equity securities if the insurer holds in its portfolio or can immediately acquire, through the exercise of options, warrants, or conversion rights already owned, the equity securities subject to call during the complete term of the call option sold; (3) Sales of covered puts on investments that the insurer is permitted to acquire under Arkansas law if the insurer has escrowed or entered into a custodian agreement segregating cash or cash equivalents with a market value equal to the amount of its purchase obligations under the put during the complete term of the put option sold; or (4) Sales of covered caps or floors if the insurer is a life and health insurer and holds in its portfolio the investments generating the cash flow to make the required payments under the caps or floors during the complete term that the cap or floor is outstanding. (e) An insurer shall include all counterparty exposure amounts in determining compliance with the limitations of § 23-63-805 . (f) The commissioner may approve additional transactions involving the use of derivative instruments in excess of the limits of subsection (c) of this section or for other risk management purposes, but replication transactions are not permitted for other risk management purposes.