ALTERNATIVE RISK TRANSFER MECHANISMS
ALTERNATIVES TO INSURANCE PRODUCTS
CREDIT SECURITISATION CAT BONDS WEATHER DERIVATIVES
CREDIT SECURITISATION
This involves transfer of assets subject to credit risk Such as receivables to a Special Purpose Company The SPC in turn issues securities backed by the transfered assets The proceeds are transfered to the transferor of assets
Credit Securitisation
The purchaser of the securities assume the risk of recovery of the assets
CAT BONDS
These are Catastrophic Bonds Are risk linked securities designed to transfer a specified set of risks from the issuer to the investors They are usually structured as corporate bonds whose repayment of principal is forgiven if certain specified trigger conditions are met
CAT BONDS
The trigger conditions are generally linked to some sort of catastrophic event such as hurricane hitting Florida If no hurricane hits the investors enjoy a return on their investment through interest rate and principal repayment over the life of the bond
CAT BONDS
If the triggering event occurs then the investors may lose their rights to some portion of the principal or even entire principal which is retained by the issuer to pay the loss
CAT BONDS
The coupon rate is much higher in CAT bonds as compared to risk free rate CAT Bonds are used where the risk sought to be defrayed is a high-severity, low frequency event.
Weather Derivatives
These are financial instruments that can be used by cojmpanies as part of risk management strategy to reduce the risk associated with Adverse or unexpected weather conditions
Weather derivatives
Weather derivative pays based on the variability of the observed weather from an index For example a weather derivative maight pay based on the number of days when a low(or high) temperature was exceeded
Weather derivatives
Farmers use weather derivatives to hedge against poor harvests that result from lack of rain or unseasonable snowstorms. Theme parks might use weather derivatives to insure against rainy weekends during peak season Energy companies have been on the forefront of the development of the weather derivatives market
Finite Risk products
These are little different from traditional insurance products Traditional insurance products have a duration of 12 months- fine risk insurance products have a longer term say 10 years
Finite Risk products
These products are useful where the risk sought to be insured against is a high severity, low frequency event such as OIL SPILL If there is a chance of an oil spill in the next 10 years as per acturial analysis The oil producer can go for a 10 year policy by finite risk contact covering the entire 10 year period
Finite Risk product
The oil producer and insurer agree to share the investment income generated by the premium If the insured risk did not materialise during the term the insured would get return of a substantial portion of the premium paid These benefits have made the finite risk products increasingly popular
CAPTIVE INSURANCE
Another method of financing losses is to make payments to a wholly owned subsidiary called CAPTIVE INSURER which pays the losses If the capitive only insures its single parent coproration and/or its subsidiaries owned by the parent , it is called PURE CAPITVE. Transactions with other sister concerns are called brother-sister transactions
Capitive unrelated business
Many captives have unrelated business. The capitve sells insurance to non-insurance corporations 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
Motivation for forming captive insurers
TAX AND REGULATORY FACTORS. Firms can reduce the tax by forming captives and paying insurance premiums than retaining the risk The extent that capitve transactions are treated as insurance transactions, firms can reduce expected tax payuments relative to retention.
Additional tax benefits canbe obtained by locating capitves offshore, in locations such as Bermuda and the Cayman islands. These tax benefits arise if the captive's income does not have to be recognised by the parent as taxable income in the year it is earned as per tax laws of the country n which the capitve is domiciled. Many offshore locations have lower tax rates on investment and underwriting income, the offshore location reduces expected tax
Additional Tax benefits
Other motivations
To allow the business to purchase excess insruance coverage directly from reinsurers. Reinsurance transactions are subject to less stringent regulations, it can reduce regulatory constraints on the transaction. i.e. By first insuring through captive which then pruchases reinsurance
Risk reduction through unrelated business
When capitve sells insurance or reinsurance to unrelated entities, in addition to to its parent corporation, the parent's loss exposures are pooled with the exposures of other entities. Consequently the risk is reduced for the parent unit
