Discussion on Insurance Risk Securitisation Essay Example

taken over capital markets. When an insurance policy is contracted, it can be turned into a financial instrument and traded on the capital market via securitization. Experts predict that securitization will continue to gain popularity in converting and marketing risks. In an article for The Economist, Peter Drucker even predicted the potential for pooling exchange rate risks and securitizing them for transfer.

According to Mr. Al Hageman, Citibank's global securitization head, over the past 20 years there has been a growing trend towards purer forms of risk transfer in securitization. This means that securitization will contain more risk transfer elements than financing. The primary goal of insurers is not to allocate funds through securitization, but rather to reduce insurance risk so they can handle large insured perils. The securitization process enables them to meet any insurance demand. In the past, primary insurers would protect themselves from large insurance risks through reinsurance.

Reinsurers are experts in the insurance industry and have specialized knowledge to spread risk, including catastrophic risks like floods, hurricanes, tropical storms, earthquakes, wildfires, volcanic eruptions, and more. However, reinsurance premiums are expensive due to transaction costs. Catastrophic events can cause insolvency or serious impairment to many reinsurers despite having insurance policies. This may result in a decrease in the volume of insurance business. Due to the high premiums and the low correlation of catastrophe losses with capital market indices, Wall Street has shown interest in finding new methods for securitizing catastrophe risk.

There is potential for competitive hedging instruments to be offered to primary insurers, providing high returns for investors in comparison to current reinsurance due to high transaction costs. Catastrophe risk is seen by

many as a new "asset class" and new instruments such as catastrophe options and catastrophe bonds have emerged. The markets for insurance risk and capital are converging, with two separate markets now performing the same function. This convergence was initially driven by the risk transfer needs of the insurance industry and the diversification benefits perceived by the capital markets, and is now accelerating.

The convergence of markets is evident in the securitization of insurance risk. Insurance companies, traditionally responsible for property and casualty risks, are now transferring the difficult-to-place risks to the capital markets through aggregate or indexed methods. Securitized insurance risk presents a compelling case for inclusion in diversified investment portfolios, though it remains uncertain whether this asset class will see sufficient growth and diversity for investment managers to allocate the necessary resources. In addition, insurers are now offering commodities, interest rate, and equity risks as part of their risk transfer packages. According to Cummins and Weiss (2004), securitization allows for unbundling and trading of contingent and predictable cash flow streams as separate financial instruments that appeal to various investor classes. These financial instruments offer reasonable returns to investors and are thus quite popular.

Securitization has a variety of benefits, including the creation of new securities that attract investors with different risk preferences. By using securitization, investors can increase their portfolio efficiency by taking on higher levels of risk. This technique creates unique securities that are not otherwise traded in capital markets, such as those related to securities mortality, catastrophic property, and longevity risk. These non-redundant securities are also beneficial for diversification purposes since they have low covariance with market systematic risk, which is

represented by Beta (average systematic risk for the market is 1).

According to Cummins (3 January 2004, p.12), diversification has the potential to decrease a portfolio's total systematic risk or average Beta, while Epetimehin (5 February 2008) contends that adding these securities can enhance portfolio efficiency for investors. Despite limited insurance transactions, securitization can improve market efficiency and capital utilization in the insurance sector. The adoption of securitization policies enables insurers to strengthen their financial position and establish a more prominent presence within the financial system.

Insurers can enhance their competitiveness by bolstering their position in the financial market, which would lead to better return on equity and operating performance. As a result, they can provide investors with secure and profitable policies that are appealing.

"Securitization allows insurers to unlock profits from insurance blocks currently held on their balance sheets and provides an alternative financing source in a heavily-regulated industry," noted Goliath on January 1st, 2005. Utilizing equity capital in lieu of traditional functions such as investment management, policy servicing, and risk-bearing creates opportunities for insurers to generate varied insurance policies and separate policy origination from these other areas.

Employing securitization of insurance risk can assist companies in diminishing their vulnerability to risk and gaining fresh, substantial financing sources for enhancing liquidity and transparency. This approach enables insurers to safeguard themselves more effectively against unfavorable underwriting when compared with conventional methods like reinsurance and letters of credit, while also acquiring inventive varieties of risk capital. Insurance companies, like any other enterprises, possess a balance sheet comprising long-term and short-term assets as well as liabilities that are usually reported at current value.

Securitization involves the assessment of assets and liabilities to

determine their current market value and then adjusting their worth accordingly. For instance, if a plant was purchased for $100,000 with a lifespan of ten years, it would be revalued to $80,000 after two years and recorded as such on the balance sheet. As Cowley and Cummins (2005) argue, any projection of an account or cash flow reflecting the present value of an asset or liability is appropriate for securitization. Essentially, securitization provides primary insurers with similar benefits to reinsurance but eliminates its drawbacks.

Insurers can generate substantial funds and decrease risk by securitizing insurance risk. This also enables them to join the capital markets. Financial investors profit from investing in these instruments, which possess lower systematic risk than other market options. Ultimately, these benefits boost the insurer's reputation and promote preference for securitization over reinsurance.

Barclays Capital-Campus Recruitment provides a glossary for capital markets on http://www.barcap.

The BNET Business Dictionary provides information on the securitization of life insurance assets and liabilities at http://resources.com/sites/v/index.jsp?vgnextoid=fc4a5bec3865c010VgnVCM1000002e14480aRCRD.The BNET website features content on securitization and enterprise risk management in the insurance sector. This information can be found at bnet.com/topic/securitization.html and jobfunctions.bnet.com/whitepaper.

According to RisPublications' article entitled "The Best of Both Worlds" from July 1999, written by Joseph Cole and Anthony Chiarenza, the information can be found at http://www.financewise via aspx?docid=65074.

The article titled "SECURITIZATION OF LIFE INSURANCE ASSETS AND LIABILITIES," authored by Cowley, Alex., and Cummins, J. David in 2005, can be found at com/public/edit/riskm/insure/ins-securit.htm. It was published in the Journal of Risk & Insurance, volume 72, issue 2, and the page numbers are 193-226. The article has a DOI of 10.

The author's name is Cox, H. Samuel and the reference number is

1111/j.1539-6975.2005.00121.x.

The website at http://www discusses the structure of securitization, as well as the actuarial and economic aspects of securitizing risk. The authors of the content are R. Joseph Fairchild and W. Hal Pedersen.

Visit casact.org/pubs/dpp/dpp99/99dpp19.pdf for the article by J. David Cummins from January 3, 2004.

The concept of securitization is studied at The Wharton School.