Transcript An Overview of NAIC Codification

ASSAL – VIII Conference on Insurance Regulation and
Supervision in Latin America
Regional Seminar on Capital Adequacy and Risk-based
Supervision
Risk Mitigation through Reinsurance
and Other Means
May 11, 2007
Bryan Fuller - NAIC Senior Reinsurance Manager
1
Outline
•
•
•
•
Purposes and Benefits of Reinsurance
Types of Reinsurance
Risk Management Framework
Alternative Risk Transfer
•
•
Captives, Finite Risk, Contingent Capital
Derivatives, Securitization
2
Elements of Reinsurance
Reinsurance is a form of insurance.
There are only two parties to the reinsurance
contract - the Reinsurer and the Reinsured both of whom are insurers, i.e. entities
empowered to insure.
The subject matter of a reinsurance contract is
the insurance liability of the Reinsured
undertaken by it under insurance policies
issued to its own policyholders.
A reinsurance contract is an indemnity
contract.
3
What Reinsurance Does
1.
It converts the risk of loss of an
insurer incurred by the reinsured under its
policies according to its own needs.
2. It redistributes the premiums received by
the reinsured, which now belong to the
reinsured, according to its own business
needs.
4
What Reinsurance Does Not Do


Reinsurance is not banking – it is
not the lending of money but it
can have the same effect.
It is not Alchemy.
Reinsurance is not a security.
Reinsurance does not:
Convert an uninsurable risk into an insurable risk.
Make loss either more or less likely to happen.
Make loss either greater or lesser in magnitude.
Convert bad business into good business.
5
Five Functions of Reinsurance
1. Capacity / Spreading Risk
Ability to write more premium while maximizing
principle of insurance.
2. Loss Control / Catastrophe Protection
Minimize financial impact from losses.
3. Financing
Providing financial resources for growth.
4. Stabilization
Minimize variations in financial results.
5. Services
Facilitate operations of insurance companies.
6
Capacity
Refers to an insurer’s ability to provide a
high limit of insurance for a single risk,
often a requirement in today’s market.
Reinsurance can help limit an insurer’s loss
from one risk to a level with which
management and shareholders are
comfortable.
Most states require that the maximum “net
retention” from one risk must be less than
10% of policyholders’ surplus.
7
Catastrophe Protection
Objective is to limit adverse effects on
P&L and surplus from a catastrophic
event to a predetermined amount.
Covers multiple smaller losses from
numerous policies issued by one
primary insurer arising from one event.
8
Financing
It is growing and needs additional surplus to
maintain acceptable premium to surplus ratios.
Unearned premium demands reduce surplus.
In a down cycle, underwriting results are bad and
reduce surplus.
Investment valuation negatively impacts surplus.
Marketing considerations dictate that an insurer
enter new lines of business or new territories.
9
Stabilization
Marketing Consideration
Policyholders and stockholders like to be
identified with a stable and well managed
company.
Management Consideration
Planning for long term growth and development
requires a more stable environment than an
insurance company’s book of business is apt to
provide.
10
Services
1.
Claims Audit
2.
Underwriting
3.
Product Development
4.
Actuarial Review
5.
Financial Advice
6.
Accounting, EDP and other systems
7.
Engineering - Loss Prevention
11
Reinsurance Contracts Basics
Proportional Reinsurance
Non-Proportional Reinsurance
Reinsurance
Contracts
Treaty
Facultative
Pro Rata
Quota Share
Surplus Share
Excess of Loss
Per Risk
Per Occurrence
Aggregate
Certificate
Semi Automatic
OR Automatic
Pro Rata
Excess of Loss
Other Considerations:
• Occurrence vs. Claims Made
• Prospective vs. Retroactive
12
Reinsurance Forms
Facultative
Protects individual risks
Offer and acceptance basis.
Reinsurer retains the right to
accept or reject each risk.
Supported by a Certificate
Certificate attaches to the
conditions on the underlying
insurance policy
Cession is optional
Individual
Risk
Treaty
Protects a large block of
business.
The reinsurer does not have
the right of rejection on a
per risk basis.
Supported by a contract
Pre-agreed conditions
Cession is obligatory
Acceptance is automatic
Book of
Business
13
Types of Agreements
Proportional
•
Quota Share
•
Surplus Share
•
Excess of Loss
14
Types of Agreements
Quota Share: Simplest type, reinsurer and reinsured share in
every loss and in the premiums at a fixed percentage.
Example: Retention 80% / Reinsurance 20%
Policy Limit Retained Amount – 80% Reinsured Amount – 20%
$100,000
$ 80,000
$20,000
$200,000
$160,000
$40,000
15
Impact of Quota Share
Quota Share 80%
Commisson Rate 30%
Override Commission 5%
6/30/05
80%
6/30/06
Before
Q/S
After
Reinsurance
Reinsurance
Reinsurance
---------------- ------------------------ ----------------------
INCOME STATEMENT
-----------PREMIUMS WRITTEN
10,000,000
(8,000,000)
CHANGE IN UPR
4,000,000
(3,200,000)
--------------------------- -----------------------PREMIUMS EARNED
6,000,000
(4,800,000)
--------------------------- -----------------------LOSSES INCURRED
3,000,000
(2,400,000)
LOSS EXP.INCURRED
550,000
(440,000)
OTHER UND. EXPENSES
3,000,000
(2,800,000)
--------------------------- -----------------------UNDERWRITING DEDUCTIONS 6,550,000
(5,640,000)
---------------- -----------------------UNDERWRITING INCOME
(550,000)
840,000
INVESTMENT INCOME
250,000
OTHER INCOME/LOSS
TAXES
0
---------------- -----------------------NET INCOME
(300,000)
840,000
========= =============
LOSS RATIO
59.17%
PW/Surplus
285.71%
Commission Ratio
30%
2,000,000
800,000
---------------------1,200,000
---------------------600,000
110,000
200,000
---------------------910,000
---------------------290,000
250,000
365,000
---------------------175,000
============
59.17%
57.14%
10%
16
80% Quota Share
ASSETS
--------------INVESTMENTS & CASH
AGENTS' BALANCES
REINSURANCE RECOV.
MISC. ASSETS
TOTAL ASSETS
=======
LIABILITIES
--------------LOSSES & LAE
REINSURANCE PAYABLE
UNEARNED PREMIUMS
OTHER EXP. & TAXES
MISC. LIABILITIES
TOTAL LIABILITIES
CAPITAL AND SURPLUS
CAPITAL
UNASSIGNED SURPLUS
REINS.BEN.
POLICYHOLDERS' SURPLUS
TOTAL LIAB. AND SURPLUS
Ratio of liab. to surplus
Before
Reinsurance
20,980,000
1,650,000
150,000
135,000
---------------------22,915,000
===========
Q/S
Reinsurance
-5,200,000
15,250,000
450,000
4,000,000
150,000
65,000
---------------------19,915,000
----------------------
-2,840,000
-5,200,000
=
-3,200,000
-6,040,000
-
2,750,000
750,000
---------------------3,500,000
---------------------23,415,000
===========
569.00%
840,000
840,000
-5,200,000
=
After Reinsurance
------------------------------15,780,000
1,650,000
150,000
135,000
------------------------------17,715,000
===============
12,410,000
450,000
800,000
150,000
65,000
------------------------------13,875,000
------------------------------2,750,000
750,000
840,000
------------------------------4,340,000
------------------------------18,215,000
===============
319.70%
17
Types of Agreements
Surplus Share: Greater flexibility. Reinsured selects
retention each risk, and cedes multiples of the retention (lines)
to the reinsurer.
Compared ceded amount to policy limit. Create a proportion.
Reinsurer chares in that proportion of loss and premiums for
each loss under that policy.
Policy Limit
Reinsured’s Share
Reinsurer’s Share
$20,000
100%
0
$40,000
50%
50%
$60,000
33.33%
66.66%
18
Quota Share Vs. Surplus Share
Both Always Pay Proportionate
Share of Any Loss
QS
Cession % the Same
for every risk
Protects Cedent’s Entire
Book
Always Obligatory
Surplus
Cession % Varies Based
on Size of each Risk and
ceding company retention
Used Mostly for Larger
Risks
Can Be Obligatory or
Non-Obligatory
19
Excess Of Loss
Reinsured retains a predetermined dollar amount (the
retention). The reinsurer then indemnifies loss excess of
that retention up to a stated limit.
•
•
•
•
Per risk excess of loss
Per risk aggregate excess of loss
Per occurrence excess
Aggregate Excess of Loss (Catastrophe)
20
Excess Of Loss
With excess of loss reinsurance no insurance is ceded and
no sharing is involved. The reinsurer promises to reimburse
the reinsured company for losses above a set retention in
return for a stated premium rather than promising to share
premiums and losses based on some proportional basis
Excess of loss reinsurance is frequently provided in layers
with the retention at each layer equal to the reinsured
company’s retention plus the reinsurance limit of the
layer(s) above. As the limits of the layer are exhausted the
next layer of excess reinsurance becomes available.
21
20
$ 10 M
95% of $ 5M xs $ 5M
Catastrophe
Excess of Loss
Cover
$5M
95% of $ 4M xs $ 1M
$1M
95% $ 500K xs $ 500K
$ 500 K
Retention
Impact of Excess of Loss
500 XS 500
Premiums = 12% PW
INCOME STATEMENT
--------------PREMIUMS WRITTEN
CHANGE IN UPR
--------------PREMIUMS EARNED
--------------LOSSES INCURRED
LOSS EXP.INCURRED
OTHER UND. EXPENSES
--------------UNDERWRITING DEDUCTIONS
UNDERWRITING INCOME
INVESTMENT INCOME
OTHER INCOME/LOSS
TAXES
NET INCOME
LOSS RATIO
PW/Surplus
Commission Ratio
6/30/05
6/30/06
Before
After
Reinsurance
Reinsurance
Reinsurance
-------------------- ------------------------------ ----------------------------
10,000,000
(1,200,000)
4,000,000
(600,000)
-------------------- -----------------------------6,000,000
(600,000)
-------------------- -----------------------------3,000,000
(420,000)
550,000
0
3,000,000
0
-------------------- -----------------------------6,550,000
(420,000)
-------------------- -----------------------------(550,000)
(180,000)
250,000
8,800,000
3,400,000
---------------------------5,400,000
---------------------------2,580,000
550,000
3,000,000
---------------------------6,130,000
---------------------------(730,000)
250,000
0
0
-------------------- ------------------------------ ---------------------------(300,000)
(180,000)
(480,000)
========== =============== ==============
59.17%
57.96%
285.71%
265.06%
30%
30%
23
Impact of Excess of Loss
Balance Sheet
ASSETS
INVESTMENTS & CASH
AGENTS' BALANCES
REINSURANCE RECOV.
MISC. ASSETS
TOTAL ASSETS
=======
LIABILITIES
--------------LOSSES & LAE
REINSURANCE PAYABLE
UNEARNED PREMIUMS
OTHER EXP. & TAXES
MISC. LIABILITIES
TOTAL LIABILITIES
CAPITAL AND SURPLUS
CAPITAL
UNASSIGNED SURPLUS
REINS.BEN.
POLICYHOLDERS' SURPLUS
TOTAL LIAB. AND SURPLUS
Ratio of liab. to surplus
6/30/05
6/30/06
20,980,000
-1,200,000
19,780,000
1,650,000
1,650,000
150,000
150,000
135,000
135,000
---------------------- ------------------------- ------------------------------22,915,000
-1,200,000
21,715,000
=========== ============ ===============
15,250,000
-420,000
14,830,000
450,000
450,000
3,500,000
-600,000
2,900,000
150,000
150,000
65,000
65,000
---------------------- ------------------------- ------------------------------19,415,000
-1,020,000
18,395,000
---------------------- ------------------------- ------------------------------2,750,000
750,000
---------------------3,500,000
---------------------22,915,000
===========
554.71%
-180,000
-------------------------180,000
-------------------------1,200,000
============
2,750,000
750,000
-180,000
------------------------------3,320,000
------------------------------21,715,000
===============
554.07%
24
Types of Agreements
EXCESS OF LOSS REINSURANCE
Type of Reinsurance
Type of Loss
Single Loss
Exceeding Retention
Accumulation of
Losses in Single
Occurrence
Exceeding Retention
Total Net Retained
Losses Over Year
Exceeding Retention
Per Risk
Excess of Loss
Per Occurrence
Excess of Loss
Aggregate
Excess of Loss
Covered
Sometimes
Covered
Not Covered
Not Covered
Covered
Not Covered
Not Covered
Not Covered
Covered
Reinsurance Program Example
$ Loss
Catastrophe
2nd Excess
1st Excess
NonProportional
Surplus Share
Retention
Quota
Share
Proportional
26
Purpose of Reinsurance Regulation
Police the Solvency of Reinsurers and Ceding
Insurers
Ensure the Collectability of Reinsurance
Recoveries
Establish and Maintain a Method of Accurate
Reporting of Financial Information Relied
Upon by Regulators, Insurers and Investors
Lacks the Consumer Protection Component
Necessary for Primary Insurers
Focuses on the Reinsurance Transaction
27
Regulation of Reinsurers
U.S. reinsurers are subject to the same entity
regulation as U.S. primary insurers, e.g., riskbased capital, holding company laws, state
licensing laws, annual statement
requirements, triennial examinations and
investment laws.
The exception is no regulation of rates and
forms.
28
Risk Management Framework
Insurer key risks might be categorized
under the following major headings:
Underwriting
Credit
Market
Operational
Liquidity
Strategic
29
Underwriting
Underwriting risks are those
associated with both the perils
covered by the specific line of
insurance (fire, death, motor
accident, windstorm, earthquake,
etc.) and the risk mitigation processes
used to manage the insurance
business.
30
Underwriting
Underwriting Process Risk
Pricing Risk
Product Design Risk
Claims Risk (for each peril)
Economic Environment Risk
Net Retention Risk
Policyholder Behavior Risk
Reserving (Provisioning) Risk
31
Credit Risk
Credit risk is the inability or unwillingness
of a counterparty to fully meet its on- or
off balance sheet contractual financial
obligations. The counterparty could be an
issuer, a debtor, a borrower, a broker, a
policyholder, a reinsurer, or a guarantor.
32
Credit Risk
An insurer might define its credit risk in terms of:
Asset classes in which it is willing to invest
Government and corporate bonds, mortgages, equities, etc.
Type of credit activity, collateral security, or real estate
and type of borrower;
Range of exposures in each asset class
Government bonds 10–20%, marketable corporate bonds 20–
40%, mortgages 10–30%, equities 5–10%)
Maximum exposure to a given credit, issuer, industry
sector, or counterparty
Chosen to limit the possible impact of a default on the surplus
of the insurer)
Transactions or exposures involving connected or
related entities.
33
Market Risk
Market risks relate to the volatility of
the market values of assets and
liabilities due to future changes of asset
prices(/yields/returns). In this respect,
the following should be taken into
account:
Market risk applies to all assets and
liabilities.
34
Market Risk
Market risk must recognize the profit
sharing linkages between the asset cash
flows and the liability cash flows (e.g.,
liability cash flows are based on asset
performance).
Market risk includes the effect of changed
policyholder behavior on the liability cash
flows due to changes in market yields and
conditions.
35
Operational Risk
The identification of insurer operational
risk involves considering all the key
functional areas of the insurer from each
of the following perspectives:
Human capital risk (for example, employing
people with the appropriate skills and
experience)
Management control risk (for example,
including appropriate sets of controls
ininternal processes and using and
communicating those controls effectively)
36
Operational Risk
System risks (for example, ensuring that
systems used in the operation of the insurer
are adequate, appropriate, reliable, and
scalable, and have adequate security,
backups, and disaster recovery plans)
Strategic risks (for example, addressing
threats to operations from competitors)
Legal risk (for example, complying with all
laws and regulations in the jurisdictions in
which the insurer operates; employing best
business practices and standards of corporate
governance; pro-actively addressing
policyholder expectations).
37
Risk Aggregation
38
Solvency I - Reinsurance
According to the present EU
legislation (Solvency I) you will get a
relief on capital up to 50 % for nonlife insurance (30 % quota share will
give 30 % relief while 60 % will give
50 %). This will change with Solvency
II and the quality of the reinsurer will
also be taken account of in the form
a credit risk rating.
39
Solvency II - Aims
Establish solvency standard to match
risks
Encourage risk control in line with
IAIS principles
Harmonise across the EU
Assets and liabilities on fair value
basis consistent with IASB if possible
40
Solvency II – New Regulations
Some European supervisors are
already attempting to meet the aims
set for Solvency II
United Kingdom, Switzerland, Sweden
(Life Insurance Only)
In all cases, the new regulation is
based on marking assets and
liabilities to market and capital
requirements based on scenario tests
or economic modelling.
41
Findings – Technical Provisions
Problem areas noted were:
Lack of resources, time and experience
Lack of data and choosing actuarial
assumptions
Derivation of Risk Margins
Treatment of Reinsurance
Wide range of methods used by
companies to produce results
42
Credit Risk – Factor Approach
Rating
CEIOPS Rating Bucket
AAA
I – Extremely Strong
0.008%
II – Very Strong
0.056%
AA
A
III – Strong
Factor
0.66%
BBB
IV – Adequate
1.312%
BB
V – Speculative
2.032%
VI – Very Speculative
4.446%
B
CCC or
Lower
Unrated
VII – Extremely Speculative
VIII – unrated
6.95%
1.6%
SCR credit risk = MV of exposure * duration * factor
43
Solvency II – Reinsurance Implications
Reinsurance constitutes exchange of insurance risk
(primarily underwriting & accumulation) for asset risk:
Asset risk carries a lower capital charge than insurance risk,
thus reinsurance can be an effective way to manage
regulatory capital needs
Factor based models do not distinguish between
proportion and non-proportional reinsurance
Risk mitigating effect of non-proportional reinsurance
compared to ceding of profits are reflected more adequately
within simulation based models
44
Effect of Reinsurance on Solvency Rules
Reinsurance provides:
Capital relief in MCR (Minimum Capital Requirement) and
SCR (Solvency Capital Requirement):
Rating of Reinsurers to be factored in The higher the rating of a reinsurer the lesser capital is
needed
Increasing tendency to cover credit risk arising from
reinsurance recoverables
• Retrospective and prospective coverage reinsurance solutions
Concentration of Credit Risk
UK FSA monitors annual premium ceded to one reinsurer
(20%) and total recoverables from any one insurance group
to not exceed 100% of capital resources
45
Risk Based Capital
Due to the diversification ability of the reinsurer, more capital is
freed up on the cedent’s side than is bound on the reinsurer’s side.
Therefore, the cost of assuming the risk is lower for the reinsurer
than for the cedent.
46
U.S. RBC Reinsurance Charge
10% charge for reinsurance recoverables.
Rationale for the Reinsurance Charge
• The apparently high charge on reinsurance
recoverables was motivated by reinsurance
collectibility problems contributed to several major
insurance company insolvencies in the mid-1980s.
Criticism of the Reinsurance Charge
Incentives:
Quality of Reinsurer:
Collateralization.
47
Types of Life Reinsurance
Indemnity
Traditional
Financial
Non-Proportional
Retrocession
Spread or Lessen Risk
Meets Financial Goals
Catastrophe, Stop Loss
Reinsurance of Reinsurance
Assumption
Transfers Business Permanently
48
Reasons for Indemnity
Reinsurance
Transfer Mortality/Morbidity Risk
Transfer Lapse or Surrender Risk
Transfer Investment Risk
Help Ceding Insurer Finance Acquisition Costs
49
Reasons for Indemnity
Reinsurance
Provide Ceding Company
•
•
•
•
Underwriting Assistance
Product Expertise
Tax Planning
Help Manage Capital and Surplus and/or RBC
Objectives
Limit Adverse Effects of Catastrophic Events
Help Enter New Market
50
Assumption Reinsurance
Sale of a block of business
Novation of a contract
Reasons For Assumption
Divesture
Raise Capital
RBC Issues
Help Ratings
Rehabilitation
51
Alternative Risk Transfer
Techniques other than traditional insurance
and reinsurance to provide risk bearing
entities with coverage or protection :
Captives
Finite Risk
Contingent Capital
Derivatives
Securitization
52
Captives
Established with the specific objective of financing risks
emanating from their parent group or groups :
Single Parent Captive
An insurance or reinsurance company formed primarily to insure the risks of
its non-insurance parent or affiliates.
Association Captive
A company owned by a trade, industry or service group for the benefit of its
members.
Group Captive
A company, jointly owned by a number of companies, created to provide a
vehicle to meet a common insurance need.
Agency Captive
A company owned by an insurance agency or brokerage firm so they may
reinsure a portion of their clients risks through that company.
Rent-a-Captive
A company that provides 'captive' facilities to others for a fee, while
protecting itself from losses under individual programs, which are also
isolated from losses under other programs within the same company. This
facility is often used for programs that are too small to justify establishing
their own captive.
53
Captives
Two other types of insurance company which have developed
recently are special purpose vehicles (SPV) and segregated
portfolio companies (SPC):
SPV - Although used extensively in the past
for various financing arrangements, recently
they have been used for catastrophe bonds
and reinsurance sidecars.
SPC - SPCs can be formed as a rent-a-captive
facility to enable those companies who lack
sufficient insurance premium volume, or who
are averse to establishing their own insurance
subsidiary, access to many of the benefits
associated with an offshore captive.
54
Captives
Captives are becoming an increasingly
important component of the risk management
and risk financing strategy of their parent. A
number of reasons have been put forward as
the basis for the growth in the use of
captives:
heavy and increasing premium costs in almost every line of
insurance coverage.
difficulties in obtaining cover certain types of risk.
differences in coverage in various parts of the world.
Inflexible credit rating structures which reflect market trends
rather than individual loss experience.
insufficient credit for deductibles and/or loss control efforts.
55
Finite Risk, Defined
Usually multiple-year
Insured (or reinsured) pays significant portion
of the losses
Time value of money plays an important role in
transaction value for both insurer and insured
Relatively narrow band between potential profit
and potential loss to counterparties
Historically, long term budgeting and financial
reporting have been key considerations
56
Does the level of risk match the
accounting treatment?
Crux of the issue because it impacts the
solvency of the cedent
Can’t always tell by the contract language
Need to review and challenge assumptions
underlying the cash flow models
Are there “side” agreements that undo the
initial risk transfer?
57
What is the right amount of risk
transfer?
“significant” loss (10/10?)
Both Underwriting and timing
“taking a drop of risk and putting in a
loan and calling it insurance is
problematic” (Robert Herz, Chairman of FASB)
No matter where line is drawn, products
will be designed to just get over the
minimum.
58
Risk Transfer
Red Flags
Provisions that require careful analysis:
• Retrospective Premiums - Premium rate is adjusted based on loss
experience.
• Sliding Scale Commissions - Commission rate is adjusted based on
loss experience.
• Contingent Commissions - Additional commission based on profit
• Floating Retentions - Ceding company’s retention is adjusted based
on the experience of the contract, last dollar paid contracts.
• Accumulating Retentions - Aggregate covers
• Loss Ratio Corridors / Loss Ratio Caps - Additional retention
by the ceding company for a lower cost of reinsurance.
59
Contingent Capital
Contingent Capital is an option which gives the
holder the right to raise capital from the option
provider at predefined terms upon the occurrence of a
pre-agreed event
The capital injected can be ( subordinated )
debt, preferred shares etc.
Other than with a normal (“knock in” )
option, the contingency is a different risk than
that of the asset underlying the option. For
example, triggers can be related to natural
hazards, the financial market, the price level
of certain commodities, the state of the
economy etc.
60
Contingent Capital
Immediate and (long) term availability of
capital at predefined costs after
“catastrophic” or unexpected events.
Prevents from having to retain large liquid
sources of capital on the balance sheet (“off
balance sheet reserve”)
Balance sheet protection against possibly
difficult to insure risks. Reduces on-balance
sheet capital without increasing overall risk
profile of company (helps e.g. solvency ratio,
capital adequacy )
61
Derivatives
Such activities expose insurance companies to systematic or
financial market risk; that is, the risk of asset and liability
holdings being affected by external (to the company) market
factors. For the insurance sector, the most important financial
market risk factors are:
Risk that interest rates may move up or down and thus affecting the
value of assets and liability holdings.
Basis risk which occurs when asset and liability portfolios are not
matched and therefore interest rate changes will have a different affect
on their total values.
Inflation risk affects the value of asset holdings and may cause
consumers to switch away from insurance products unless returns
compensate for reduced purchasing power.
Foreign currency risk which occurs when investments or assets are held
in a currency which devalues relative to the home currency.
Movements in stock prices, which means that the value of investments
in stock markets affect the ability of insurance firms to pay out
competitive rates of return to their policy holders.
62
Derivatives
There are four major derivative instruments:
Forwards are contracts negotiated over the counter between
two private parties. They involve the obligation to either buy or
sell an underlying asset at a prespecified price and date in the
future and are privately negotiated between two parties. They
have the advantage of being highly flexible with regard to terms
and conditions. However, they have the possibility to provide
counterparty credit risk and low trading liquidity because of
non-standardised negotiated terms.
Futures contracts also involve the obligation to buy or sell an
underlying asset at a prespecified price and date in the future.
Unlike forwards, they are standardised with regard to delivery,
quantity, and quality. They are listed and traded on formal
exchanges in which the clearing house manages and
coordinates all trades and guarantees delivery or settlement of
the contract. Moreover, they require maintenance margins that
are settled daily by the clearing house, thus, virtually eliminating
credit risk. Consequently, such contracts generally provide high
trading liquidity.
63
Derivatives
Swaps are private contracts between two participants who
agree to exchange their different cash flows that might arrive in
the future. A common example is an ‘interest rate swap’,
whereby the parties agree to exchange the cash flows arising
from fixed and variable interest rate payments on specified
principal amounts.
Options provide the buyer the right, but not the obligation, to
buy or sell the underlying asset at a pre-specified time and price
in the future. Options have a number of characteristics that are
similar to an insurance contract. For the purchaser of a call
option returns on the upside are unlimited.
For example, a contract to buy stock at $100 will be invoked if the
stock is trading for any amount greater than $100 at the expiration
of the contract. However, on the downside the loss is limited to the
price of the call option. This call option contract protects the holder
against price rises that will potentially occur in the future and is a
similar payoff to taking out insurance that is conditional on a
specified event occurring (such as flood). On the other hand, the
writer of the option undertakes to cover the call upside risk (or
downside for a put option) in return for the price of the written
option. This is a similar position to the writer of an insurance
contract.
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Securitization
Securitization of insurance risks enables
insurers to transfer their insurance risk
directly to investors in the capital markets:
Insurance company transfers
underwriting risks to the capital markets
by transforming underwriting cash
flows into tradable financial securities
Cash flows (e.g., repayment of interest
and/or principal) are contingent upon
an insurance event / risk
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Factors Affecting Insurance Securitization
Recent catastrophe experience
Reassessment of catastrophe risk
Demand for and pricing of reinsurance
Reinsurance supply issues
Capital market developments
Development of new asset classes and
asset-backed markets
Search for yield and diversification
Restructuring of insurance industry
Possible Reasons for Securitization
Capacity
Risk of huge catastrophe losses
Would severely impair P/C industry capital
Capital markets could handle
Investment
Catastrophe exposure is uncorrelated with
overall capital markets. Thus, uncorrelated
with existing portfolios.
Diversification potential
Potential Success of Insurance
Securitization?
Difficult to understand
Capital markets
Insurance markets
Separation of insurance and finance
functions in many companies
Information and technology
Difficult to price
Expensive (vs. cat. reinsurance market)
Legal / tax / accounting issues
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