alternative risk transfers

7/31/2019 Alternative Risk Transfers

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ALTERNATIVE RISK TRANSFER

MECHANISMS

ALTERNATIVES TO INSURANCEPRODUCTS


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CREDIT SECURITISATION

CAT BONDS

WEATHER DERIVATIVES


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CREDIT SECURITISATION

This involves transfer of assets subject to

credit riskSuch as receivables to a Special PurposeCompany

The SPC in turn issues securities backed by

the transfered assetsThe proceeds are transfered to the transferorof assets


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Credit Securitisation

The purchaser of the securities assume therisk of recovery of the assets


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CAT BONDS

These are Catastrophic Bonds

Are risk linked securities designed to transfera specified set of risks from the issuer to theinvestors

They are usually structured as corporatebonds whose repayment of principal isforgiven if certain specified trigger

conditions are met


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CAT BONDS

The trigger conditions are generally linked to

some sort of catastrophic event such ashurricane hitting Florida

If no hurricane hits the investors enjoy a

return on their investment through interestrate and principal repayment over the life ofthe bond


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CAT BONDS

If the triggering event occurs then theinvestors may lose their rights to someportion of the principal or even entire

principal which is retained by the issuer topay the loss


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CAT BONDS

The coupon rate is much higher in CAT bondsas compared to risk free rate

CAT Bonds are used where the risk sought to

be defrayed is a high-severity, lowfrequency event.


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Weather Derivatives

These are financial instruments that can beused by cojmpanies as part of risk

management strategy to reduce the riskassociated with

Adverse or unexpected weather conditions


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Weather derivatives

Weather derivative pays based on thevariability of the observed weather from anindex

For example a weather derivative maight pay

based on the number of days when a low(orhigh) temperature was exceeded


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Weather derivatives

Farmers use weather derivatives to hedgeagainst poor harvests that result from lack

of rain or unseasonable snowstorms.

Theme parks might use weather derivativesto insure against rainy weekends during

peak season

Energy companies have been on the forefrontof the development of the weather

derivatives market


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Finite Risk products

These are little different from traditionalinsurance products

Traditional insurance products have a

duration of 12 months- fine risk insuranceproducts have a longer term say 10 years


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Finite Risk products

These products are useful where the risksought to be insured against is a high

severity, low frequency event such as OILSPILL

If there is a chance of an oil spill in the next

10 years as per acturial analysisThe oil producer can go for a 10 year policyby finite risk contact covering the entire 10

year period


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Finite Risk product

The oil producer and insurer agree to sharethe investment income generated by the

premium

If the insured risk did not materialise duringthe term the insured would get return of a

substantial portion of the premium paid

These benefits have made the finite riskproducts increasingly popular


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CAPTIVE INSURANCE

Another method of financing losses is tomake payments to a wholly owned subsidiary

called CAPTIVE INSURER which pays the

losses

If the capitive only insures its single parentcoproration and/or its subsidiaries owned by

the parent , it is called PURE CAPITVE.

Transactions with other sister concerns arecalled brother-sister transactions


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Capitive unrelated business

Many captives have unrelated business.

The capitve sells insurance to non-insurancecorporations that are not owned by the

captive's parents

In addition many captives engage in

reinsurance transactions with other insurers(including other capitves)

Some captives have multiple parents these

are called Group captives


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Motivation for forming captiveinsurers

TAX AND REGULATORY FACTORS.

Firms can reduce the tax by forming captivesand paying insurance premiums than

retaining the risk

The extent that capitve transactions aretreated as insurance transactions, firms canreduce expected tax payuments relative to

retention.


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Additional Tax benefitsAdditional tax benefits canbe obtained bylocating capitves offshore, in locations such

as Bermuda and the Cayman islands.

These tax benefits arise if the captive'sincome does not have to be recognised by

the parent as taxable income in the year it isearned as per tax laws of the country n

which the capitve is domiciled.

Many offshore locations have lower tax rateson investment and underwriting income, the

offshore location reduces expected tax


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Other motivations

To allow the business to purchase excessinsruance coverage directly from reinsurers.

Reinsurance transactions are subject to lessstringent regulations, it can reduce regulatory

constraints on the transaction.

i.e. By first insuring through captive whichthen pruchases reinsurance


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Risk reduction through unrelatedbusiness

When capitve sells insurance or reinsurance

to unrelated entities, in addition to to itsparent corporation, the parent's loss

exposures are pooled with the exposures ofother entities.

Consequently the risk is reduced for theparent unit

alternative risk transfers

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