Trading in insurance risk is a common activity using the well established re-insurance market. However, over the last seven years or so there has been increased activity in insurance risk securitisation, this has had a significant impact on the classical use of re-insurance markets and enabled insurers to go to capital markets rather than insurance markets. The securitisation process enables insurance companies to reduce risk and structure their products so that the capital market absorbs the risk, and there is the opportunity to diversity funding.
Discussing the matters of above paragraph we are to know about the following terms: Insurance Insurance is defined as a co-operative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to ensure themselves against that risk. Risk is uncertainty of financial loss. Every risk involves the loss of one or other kind. The function of insurance is to spread the loss over a large number of persons who are agreed to co-operate each other at the time of loss.
Oxford Dictionary of Business define insurance as “A legal contract in which an insurer promises to pay a specified amount to another party, the insured, if a particular event (known as the peril), happens and the insured suffers a financial loss as a result. The insured part of the contract is to promise to pay an amount of money, known as the premium, either once or regular intervals. ” Insurance Risk “Insurance is a device to share the financial losses which might befall on an individual or his family on the happening of special event” Kaur, (n.
d. , p. 4). The event can be death of a bread-winner to the family in the case of life insurance, marine-perils in marine insurance, fire in fire insurance and other certain events in general insurance, e. g, theft in burglary insurance, accident in motor insurance, etc. These events may occur any time within the insured period. The insurer has to provide a fixed amount or indemnify the amount of occurred due to the insured perils. Hence, insurers bear a great risk of paying huge amount of fund at any time if the insured peril is occurred.
As large as the insured amount and the probability of happening insured peril, the Insurance Risk for insurers is large. Reinsurance Reinsurance is an arrangement whereby an original insurer who has insured a risk insures a part of that risk again with another insurer, that is to say, reinsures a part of the risk in order to diminish his own liability. According to the Oxford Dictionary of Business, ”the passing of all or part of an insurance risk that has been covered by an insurer to another insurer in return for a premium.
The contract between the parties is usually known as a reinsurance treaty. The policyholder is usually not aware that reinsurance has been arranged as no mention is made of it on the policy. ” Advantages of Reinsurance 1. The original insurer can accept the risk to the extent of his limit. In absence of reinsurance, a person desiring a large amount of insurance will have to take a number of policies from several insurers. The reinsurance contract makes it possible to purchase only one policy from an insurer. 2.
Reinsurance makes it possible to accept each risk for the very amount desired by the proposer and to transfer the excess above the ‘retention limit’ to another insurer. 3. The reinsurance gives the benefit of the greater stability resulting from a widespread of business. By accepting many risks and scaling down, by reinsurance, all those that are larger than the normal carrying capacity of the insurer justifies, certainly in business is substituted for uncertainty through the better application of the law of average. 4.
The insurance makes stability in underwriting and consistency in underwriting results over a period. 5. It provides a safeguard against serious effects of conflagration. 6. The reinsurance has the effect of stabilizing income and losses over a period of years. Capital Market The capital markets consist of the markets in which the intermediate and long-term securities of individuals, business firms, and governmental units are issued and traded. Capital markets are frequently subdivided into three parts-the bond market, the mortgage market, and the stock market.
On the other word, capital market is the market where “long-term capital is raised by industry and commerce, the government, and local authorities” (Barclays Capital-Campus Recruitment, n. d. ). The Glossary of Capital Market states that “stock exchanges are also part of the capital market for the shares and loan stocks that represent the capital once it has been raised” (TUTOR2U), Securitization At present world, securitization is one of the most important innovations. We can get a clear idea about securitization by the help of following explanation of securitization, which are provided by various authors and organigations.
In the broad sense, securitization means “bundling or repackaging of rights of future cash flows for sale in capital markets”(Sankarreddy, December 2004). The repacking provides a more efficient allocation of risk. This process can be costly, but evidently the reallocation is valuable enough to make it worthwhile. BNET Business Dictionary (n. d. ) states that “the securitization process involves the isolation of a pool of assets or rights to a set of cash flows and the repackaging of the asset or cash flows into securities that are traded in capital markets.
” The era of securitization began in the 1970s with the securitization of mortgage loans by the government sponsored enterprise (GSEs) Fannie Mae, Ginnie Mae, and Freddie Mac. “The Federal government creates these agencies with the objective of facilitating home ownership by providing a reliable supply of home mortgage financing” (Cowley and Cummins, 2005). The Dutch regulator De Nederlandsche Bank defined securitization in 2003 as: “Securitisation is the process whereby non-tradable assets such as mortgage loans and corporate loans are pooled and converted into securities.
Securitisation is mostly done through separate legal entities, often called special purpose vehicles (SPV’s) and involves the sale to the SPV of financial assets by their original owners, the originators. To fund their purchases, SPV’s issue asset backed securities (ABS) whose repayment and interest payments are made from cash flows generated by securitised assets. ” Structure of Securitisation Cox, Fairchild and Pedersen, provides that “The securitization technology applies to many kinds of risk.
In asset and liability securitization the common structure generally involves four entities: retail customers, a retail contract issuer, a special purpose company, and investors. We can see the following four entities in case of catastrophe risk bonds: 1. Homeowners who buy policies from an insurer. 2. The insurance company that issues the homeowners policies (that is, the retail contracts) and buys reinsurance from a special purpose reinsurer (that is, the special purpose company). 3. The special purpose reinsurer that issues the reinsurance and sells bonds 4. Investors who buy the bonds. ” (p. 6)