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Prepared By: Kriti Angra Roll no. 04 MBA-AS

RISK TRANSFER MECHANISMS

+INTRODUCTION Risk Transfer: It is an agreement under which some entity other than

the one experiencing the loss bears directs financial consequences. Risk of loss may be transferred by one entity to another in a variety of ways:-

Insurance (transfer to an insurer under an insurance contract)

Judicial (transfer to another party by virtue of a successful legal action)

Contractual (transfer to another party under contracts other than insurance)

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+ Risk transfer mechanisms comprise a two

group of financial instruments: Credit linked securities (credit derivatives)

used to transfer risks to another party in the form of borrowers defaulting on their debt (i.e. borrowers are not repaying debt).

Insurance linked securities such as some ART products and Catastrophe bonds are designed to shed risks from underlying insurance risks.

+CLASSICAL RISK TRANFORMATION PRODUCTS Securitization:  The pooling of loans and/or receivables and selling

that pool of assets to a third-party, a special purpose vehicle (SPV).The risks associated with that pool of assets, such as credit risk, are transferred to the SPV. In turn, the SPV obtains the funds to acquire the pool of assets by selling securities.

When the pool of assets consists of consumer receivables or mortgage loans, the securities issued are referred to as asset-backed securities

When the pool consists of corporate loans, the securities are collateralized loan obligations.

+ Credit Derivatives: These allow investors to either acquire or reduce

credit risk exposure. Credit derivatives allow default risk to be transferred without modifying the legal ownership of the underlying assets and without having to refinance the loan.

Credit default swaps (CDS) - protects the buyer from the default of a company or sovereign borrower in return for a periodic fee similar to an insurance premium.

Synthetic collateralized loan obligation (CLO) - transfers the credit risk exposure by buying credit protection for the same pool of corporate loans.

+ Insurance:It is a risk transfer mechanism enabling a firm

to transfer the loss arising from some specific (risks), peril(s), or hazard(s) from the equity holders of the insurance purchaser to the equity holders of the insurance provider.

The process by which an insurance company assumes risk thus is known as underwriting, and the lead insurer is called the lead underwriter.

 

+ Reinsurance: It is insurance protection purchased by

insurance companies. To hedge portfolios of insurance risks that

exceed their retention levelsFacultative agreements- which are intended to

cover individual risks.Treaty agreements- which are intended to

cover portfolios of risks.

+ALTERNATIVE RISK TRANSFER PRODUCTS Captives:An insurance or reinsurance vehicle that

belongs to a company or group of companies that is not active in the insurance industry itself.

Insures the risks of its parent company.An instrument for self-financing risks.

+ Contingent Capital:Is a pre-loss alternative risk transfer product

that enables insurance or reinsurance company with the possibility to issue securities such as equities and bonds and structured securities such as catastrophe bonds.

Is low-cost off-balance sheet alternative that provides conditional coverage upon the occurrence of some triggering insurable event.

Provides Insurers and reinsurers with the right, but not the obligation, to issue specified security.

+ Insurance Derivatives:Financial derivatives that are used for

insurance risk hedging.Enables insurance and reinsurance companies

to transfer insurance risks to capital market investors and serve as a complement to traditional reinsurance.

Include futures, options, catastrophe swaps and industry loss warranties.

+ Sidecars: Similarities to cat bonds and traditional

reinsurance and can be used as a supplement to both.

Used as a temporary vehicle to ease capacity constraints or allow a firm to write more business than it would otherwise.

For example, sidecars were widely used to provide temporary capacity for the US catastrophe market in the aftermath of Hurricane Katrina.

+ Catastrophe Bonds:Risk-linked securities that transfer a specified

set of risks from the sponsor to capital markets investors through a fully collateralized special purpose vehicle (SPV).

Catastrophe bonds are written on the basis of predefined natural catastrophes, typically an earthquake, a hurricane or a wind storm.

The SPV issues floating-rate bonds of which the principal is used to pay losses if specified trigger conditions are met.

+ Finite Risk: Based on the spreading of individual risks over time. Key features Of Finite Risk are:

Assumptions of limited risk by insurer. Multi-year contract term. Sharing of result with client. Depends on tax regimes and regulatory conditions. Strong Demand for solutions that combine finite

and traditional insurance elements

+ Types (Past) Loss portfolio transfers (LPTs)

Policyholders transfer outstanding claims reserves to the insurer.

Retrospective excess of loss covers (RXLs) Offer broader spectrum of cover than LPTs. No transfer of outstanding claims reserves.

Types (Present) Financial Quota share reinsurance (FQR) Prospective excess of loss covers (PXLs)

+ Integrated multi-line/multi-year products (MMPs):

Combines different categories of risk in one product.

Key features of MMPs are: Bundling of different categories of risk over

several years Allow substantial risk to be transferred. Stabilization of risk costs.

Hurdles for slow growth because of high transaction costs. Credit risks is existent.

+ Multi-trigger products (MTPs): Key Features are:

Two triggers for claims to be paid are:- An insurance event A non-insurance event

Key benefits are:Protection provided from disaster scenarios

and price falls in equity or bond markets in the same financial year.

Price advantage.

+ BENEFITS OF RISK TRANSFER MECHANISMS Greater dispersion and improved distribution of risk The arrival of new non-bank players has resulted in

greater risk dispersion and increased market efficiency.

Banks themselves may buy risk. Resilience of the system to shocks e.g.- General

Motors Capital optimization