Reinsurance ASSAL by dominic.cecilia


									ASSAL – VIII Conference on Insurance Regulation and
            Supervision in Latin America
Regional Seminar on Capital Adequacy and Risk-based
     Risk Mitigation through Reinsurance
              and Other Means
                May 11, 2007

    Bryan Fuller - NAIC Senior Reinsurance Manager

•   Purposes and Benefits of Reinsurance
•   Types of Reinsurance
•   Risk Management Framework
•   Alternative Risk Transfer
    •   Captives, Finite Risk, Contingent Capital
    •   Derivatives, Securitization

       Elements of Reinsurance
Reinsurance is a form of insurance.
There are only two parties to the reinsurance
contract - the Reinsurer and the Reinsured -
both of whom are insurers, i.e. entities
empowered to insure.
The subject matter of a reinsurance contract is
the insurance liability of the Reinsured
undertaken by it under insurance policies
issued to its own policyholders.
A reinsurance contract is an indemnity

              What Reinsurance Does
1.       It converts the risk of loss of an
     insurer incurred by the reinsured under its
     policies according to its own needs.

2. It redistributes the premiums received by
   the reinsured, which now belong to the
   reinsured, according to its own business

          What Reinsurance Does Not Do
   Reinsurance is not banking – it is
    not the lending of money but it       It is not Alchemy.
    can have the same effect.
   Reinsurance is not a security.

Reinsurance does not:
     Convert an uninsurable risk into an insurable risk.
     Make loss either more or less likely to happen.
     Make loss either greater or lesser in magnitude.
     Convert bad business into good business.

  Five Functions of Reinsurance

1. Capacity / Spreading Risk
     Ability to write more premium while maximizing
      principle of insurance.
2. Loss Control / Catastrophe Protection
     Minimize financial impact from losses.
3. Financing
     Providing financial resources for growth.
4. Stabilization
     Minimize variations in financial results.
5. Services
     Facilitate operations of insurance companies.

Refers to an insurer’s ability to provide a
high limit of insurance for a single risk,
often a requirement in today’s market.
Reinsurance can help limit an insurer’s loss
from one risk to a level with which
management and shareholders are
Most states require that the maximum “net
retention” from one risk must be less than
10% of policyholders’ surplus.

        Catastrophe Protection
Objective is to limit adverse effects on
P&L and surplus from a catastrophic
event to a predetermined amount.

Covers multiple smaller losses from
numerous policies issued by one
primary insurer arising from one event.

It is growing and needs additional surplus to
maintain acceptable premium to surplus ratios.
Unearned premium demands reduce surplus.
In a down cycle, underwriting results are bad and
reduce surplus.
Investment valuation negatively impacts surplus.
Marketing considerations dictate that an insurer
enter new lines of business or new territories.

Marketing Consideration
Policyholders and stockholders like to be
identified with a stable and well managed

Management Consideration
Planning for long term growth and development
requires a more stable environment than an
insurance company’s book of business is apt to

1.   Claims Audit
2.   Underwriting
3.   Product Development
4.   Actuarial Review
5.   Financial Advice
6.   Accounting, EDP and other systems
7.   Engineering - Loss Prevention

              Reinsurance Contracts Basics
       Proportional Reinsurance
    Non-Proportional Reinsurance

                                 Treaty                                                            Facultative

                                                                                                           Semi Automatic
          Pro Rata                                   Excess of Loss                  Certificate
                                                                                                           OR Automatic

Quota Share      Surplus Share            Per Risk   Per Occurrence      Aggregate   Pro Rata               Excess of Loss

Other Considerations:
 • Occurrence vs. Claims Made
 • Prospective vs. Retroactive

                   Reinsurance Forms
Facultative                      Treaty
Protects individual risks
                                 Protects a large block of
Offer and acceptance basis.      business.
Reinsurer retains the right to   The reinsurer does not have
accept or reject each risk.      the right of rejection on a
Supported by a Certificate       per risk basis.
                                 Supported by a contract
Certificate attaches to the      Pre-agreed conditions
conditions on the underlying
insurance policy                 Cession is obligatory

Cession is optional              Acceptance is automatic

         Individual                     Book of
            Risk                        Business
    Types of Agreements

   •   Quota Share

   •   Surplus Share

   •   Excess of Loss

       Types of Agreements
Quota Share: Simplest type, reinsurer and reinsured share in
every loss and in the premiums at a fixed percentage.

 Example: Retention 80% / Reinsurance 20%

Policy Limit Retained Amount – 80% Reinsured Amount – 20%
 $100,000           $ 80,000               $20,000
 $200,000           $160,000               $40,000

        Impact of Quota Share
Quota Share 80%
Commisson Rate 30%                    6/30/05                80%                   6/30/06
Override Commission 5%                Before                  Q/S                    After
                                   Reinsurance          Reinsurance             Reinsurance
                                   ---------------- ------------------------ ----------------------
   PREMIUMS WRITTEN       10,000,000                (8,000,000)                      2,000,000
   CHANGE IN UPR            4,000,000               (3,200,000)                         800,000
   ------------           ---------------- ------------------------          ----------------------
   PREMIUMS EARNED          6,000,000               (4,800,000)                      1,200,000
   ------------           ---------------- ------------------------          ----------------------
   LOSSES INCURRED          3,000,000               (2,400,000)                         600,000
   LOSS EXP.INCURRED          550,000                  (440,000)                        110,000
   OTHER UND. EXPENSES      3,000,000               (2,800,000)                         200,000
   ------------           ---------------- ------------------------          ----------------------
   UNDERWRITING DEDUCTIONS 6,550,000                (5,640,000)                         910,000
                          ---------------- ------------------------          ----------------------
   UNDERWRITING INCOME       (550,000)                  840,000                         290,000
   INVESTMENT INCOME          250,000                                                   250,000
   TAXES                               0                                                365,000
                          ---------------- ------------------------          ----------------------
   NET INCOME                (300,000)                  840,000                         175,000
                          ========= =============                            ============
   LOSS RATIO                   59.17%                                                   59.17%
   PW/Surplus                 285.71%                                                    57.14%
   Commission Ratio                 30%                                                      10%
             80% Quota Share
ASSETS                            Before                  Q/S      After Reinsurance
---------------             Reinsurance              Reinsurance   -------------------------------
INVESTMENTS & CASH                20,980,000          -5,200,000                  15,780,000
AGENTS' BALANCES                    1,650,000                                       1,650,000
REINSURANCE RECOV.                     150,000                                        150,000
MISC. ASSETS                           135,000                                        135,000
                            ----------------------        -        -------------------------------
TOTAL ASSETS                      22,915,000         -5,200,000                   17,715,000
=======                     ===========                   =        ===============
LOSSES & LAE                      15,250,000         -2,840,000                   12,410,000
REINSURANCE PAYABLE                    450,000                                        450,000
UNEARNED PREMIUMS                   4,000,000        -3,200,000                       800,000
OTHER EXP. & TAXES                     150,000                                        150,000
MISC. LIABILITIES                        65,000                                         65,000
                            ----------------------        -        -------------------------------
TOTAL LIABILITIES                 19,915,000         -6,040,000                   13,875,000
                            ----------------------        -        -------------------------------
CAPITAL                            2,750,000                                        2,750,000
UNASSIGNED SURPLUS                   750,000                                          750,000
REINS.BEN.                                             840,000                        840,000
                            ----------------------        -        -------------------------------
POLICYHOLDERS' SURPLUS              3,500,000          840,000                      4,340,000
                            ----------------------        -        -------------------------------
TOTAL LIAB. AND SURPLUS           23,415,000         -5,200,000                   18,215,000
                            ===========                   =        ===============
Ratio of liab. to surplus             569.00%                                         319.70%

        Types of Agreements
Surplus Share: Greater flexibility. Reinsured selects
retention each risk, and cedes multiples of the retention (lines)
to the reinsurer.
Compared ceded amount to policy limit. Create a proportion.
Reinsurer chares in that proportion of loss and premiums for
each loss under that policy.

 Policy Limit      Reinsured’s Share        Reinsurer’s Share
  $20,000                100%                       0
  $40,000                 50%                       50%
  $60,000                 33.33%                    66.66%

            Quota Share Vs. Surplus Share
       Both Always Pay Proportionate
             Share of Any Loss
       QS                          Surplus
Cession % the Same         Cession % Varies Based
for every risk             on Size of each Risk and
                           ceding company retention
Protects Cedent’s Entire
Book                       Used Mostly for Larger
Always Obligatory          Can Be Obligatory or

       Excess Of Loss
Reinsured retains a predetermined dollar amount (the
retention). The reinsurer then indemnifies loss excess of
that retention up to a stated limit.

  •   Per risk excess of loss
  •   Per risk aggregate excess of loss
  •   Per occurrence excess
  •   Aggregate Excess of Loss (Catastrophe)

      Excess Of Loss
With excess of loss reinsurance no insurance is ceded and
no sharing is involved. The reinsurer promises to reimburse
the reinsured company for losses above a set retention in
return for a stated premium rather than promising to share
premiums and losses based on some proportional basis

Excess of loss reinsurance is frequently provided in layers
with the retention at each layer equal to the reinsured
company’s retention plus the reinsurance limit of the
layer(s) above. As the limits of the layer are exhausted the
next layer of excess reinsurance becomes available.

                 $ 10 M

                           95% of $ 5M xs $ 5M
Excess of Loss


                           95% of $ 4M xs $ 1M

                           95% $ 500K xs $ 500K
                 $ 500 K
    Impact of Excess of Loss
500 XS 500                        6/30/05                                                 6/30/06
Premiums = 12% PW                 Before                                                   After
                              Reinsurance              Reinsurance                    Reinsurance
                             -------------------- ------------------------------ ----------------------------
   PREMIUMS WRITTEN             10,000,000                      (1,200,000)                     8,800,000
   CHANGE IN UPR                  4,000,000                        (600,000)                    3,400,000
   ---------------           -------------------- ------------------------------   ----------------------------
   PREMIUMS EARNED                6,000,000                        (600,000)                    5,400,000
   ---------------           -------------------- ------------------------------   ----------------------------
   LOSSES INCURRED                3,000,000                        (420,000)                    2,580,000
   LOSS EXP.INCURRED                550,000                                   0                   550,000
   OTHER UND. EXPENSES            3,000,000                                   0                 3,000,000
   ---------------           -------------------- ------------------------------   ----------------------------
   UNDERWRITING DEDUCTIONS        6,550,000                        (420,000)                    6,130,000
                             -------------------- ------------------------------   ----------------------------
   UNDERWRITING INCOME             (550,000)                       (180,000)                     (730,000)
   INVESTMENT INCOME                250,000                                                       250,000
   TAXES                                      0                                                           0
                             -------------------- ------------------------------ ----------------------------
   NET INCOME                      (300,000)                       (180,000)                   (480,000)
                             ========== =============== ==============
   LOSS RATIO                         59.17%                                                      57.96%
   PW/Surplus                       285.71%                                                     265.06%
   Commission Ratio                       30%                                                         30%

    Impact of Excess of Loss
Balance Sheet                    6/30/05                                                  6/30/06
INVESTMENTS & CASH                20,980,000                 -1,200,000                     19,780,000
AGENTS' BALANCES                    1,650,000                                                 1,650,000
REINSURANCE RECOV.                     150,000                                                  150,000
MISC. ASSETS                           135,000                                                  135,000
                            ---------------------- ------------------------- -------------------------------
TOTAL ASSETS                      22,915,000                 -1,200,000                     21,715,000
=======                     =========== ============ ===============
LOSSES & LAE                      15,250,000                    -420,000                    14,830,000
REINSURANCE PAYABLE                    450,000                                                  450,000
UNEARNED PREMIUMS                   3,500,000                   -600,000                      2,900,000
OTHER EXP. & TAXES                     150,000                                                  150,000
MISC. LIABILITIES                        65,000                                                   65,000
                            ---------------------- ------------------------- -------------------------------
TOTAL LIABILITIES                 19,415,000                 -1,020,000                     18,395,000
                            ---------------------- ------------------------- -------------------------------
CAPITAL                            2,750,000                                                      2,750,000
UNASSIGNED SURPLUS                   750,000                                                        750,000
REINS.BEN.                                                        -180,000                         -180,000
                            ----------------------   -------------------------   -------------------------------
POLICYHOLDERS' SURPLUS              3,500,000                     -180,000                        3,320,000
                            ----------------------   -------------------------   -------------------------------
TOTAL LIAB. AND SURPLUS           22,915,000                   -1,200,000                       21,715,000
                            ===========              ============                ===============
Ratio of liab. to surplus             554.71%                                                      554.07%
Types of Agreements
                                    Type of Reinsurance
   Type of Loss
                         Per Risk      Per Occurrence     Aggregate
                      Excess of Loss   Excess of Loss   Excess of Loss
Single Loss                             Sometimes
                         Covered                        Not Covered
Exceeding Retention                      Covered
Accumulation of
Losses in Single
Occurrence            Not Covered         Covered       Not Covered
Exceeding Retention
Total Net Retained
Losses Over Year
                      Not Covered       Not Covered        Covered
Exceeding Retention
Reinsurance Program Example


               2nd Excess
  $ Loss

               1st Excess
              Surplus Share
                        Quota   Proportional

    Purpose of Reinsurance Regulation
Police the Solvency of Reinsurers and Ceding
Ensure the Collectability of Reinsurance
Establish and Maintain a Method of Accurate
Reporting of Financial Information Relied
Upon by Regulators, Insurers and Investors
Lacks the Consumer Protection Component
Necessary for Primary Insurers
Focuses on the Reinsurance Transaction

     Regulation of Reinsurers

U.S. reinsurers are subject to the same entity
regulation as U.S. primary insurers, e.g., risk-
based capital, holding company laws, state
licensing laws, annual statement
requirements, triennial examinations and
investment laws.
The exception is no regulation of rates and

     Risk Management Framework
Insurer key risks might be categorized
under the following major headings:

Underwriting risks are those
associated with both the perils
covered by the specific line of
insurance (fire, death, motor
accident, windstorm, earthquake,
etc.) and the risk mitigation processes
used to manage the insurance

Underwriting Process Risk
Pricing Risk
Product Design Risk
Claims Risk (for each peril)
Economic Environment Risk
Net Retention Risk
Policyholder Behavior Risk
Reserving (Provisioning) Risk
                   Credit Risk
Credit risk is the inability or unwillingness
of a counterparty to fully meet its on- or
off balance sheet contractual financial
obligations. The counterparty could be an
issuer, a debtor, a borrower, a broker, a
policyholder, a reinsurer, or a guarantor.

                            Credit Risk
An insurer might define its credit risk in terms of:
       Asset classes in which it is willing to invest
          Government and corporate bonds, mortgages, equities, etc.
       Type of credit activity, collateral security, or real estate
       and type of borrower;
       Range of exposures in each asset class
          Government bonds 10–20%, marketable corporate bonds 20–
          40%, mortgages 10–30%, equities 5–10%)
       Maximum exposure to a given credit, issuer, industry
       sector, or counterparty
          Chosen to limit the possible impact of a default on the surplus
          of the insurer)
       Transactions or exposures involving connected or
       related entities.
                 Market Risk
Market risks relate to the volatility of
the market values of assets and
liabilities due to future changes of asset
prices(/yields/returns). In this respect,
the following should be taken into
   Market risk applies to all assets and

                Market Risk
Market risk must recognize the profit
sharing linkages between the asset cash
flows and the liability cash flows (e.g.,
liability cash flows are based on asset
Market risk includes the effect of changed
policyholder behavior on the liability cash
flows due to changes in market yields and

              Operational Risk
The identification of insurer operational
risk involves considering all the key
functional areas of the insurer from each
of the following perspectives:
  Human capital risk (for example, employing
  people with the appropriate skills and
  Management control risk (for example,
  including appropriate sets of controls
  ininternal processes and using and
  communicating those controls effectively)
          Operational Risk
System risks (for example, ensuring that
systems used in the operation of the insurer
are adequate, appropriate, reliable, and
scalable, and have adequate security,
backups, and disaster recovery plans)
Strategic risks (for example, addressing
threats to operations from competitors)
Legal risk (for example, complying with all
laws and regulations in the jurisdictions in
which the insurer operates; employing best
business practices and standards of corporate
governance; pro-actively addressing
policyholder expectations).             37
Risk Aggregation

    Solvency I - Reinsurance
According to the present EU
legislation (Solvency I) you will get a
relief on capital up to 50 % for non-
life insurance (30 % quota share will
give 30 % relief while 60 % will give
50 %). This will change with Solvency
II and the quality of the reinsurer will
also be taken account of in the form
a credit risk rating.

             Solvency II - Aims
Establish solvency standard to match
Encourage risk control in line with
IAIS principles
Harmonise across the EU
Assets and liabilities on fair value
basis consistent with IASB if possible

Solvency II – New Regulations
Some European supervisors are
already attempting to meet the aims
set for Solvency II
  United Kingdom, Switzerland, Sweden
  (Life Insurance Only)
In all cases, the new regulation is
based on marking assets and
liabilities to market and capital
requirements based on scenario tests
or economic modelling.

Findings – Technical Provisions
Problem areas noted were:
  Lack of resources, time and experience
  Lack of data and choosing actuarial
  Derivation of Risk Margins
  Treatment of Reinsurance
Wide range of methods used by
companies to produce results

         Credit Risk – Factor Approach
Rating             CEIOPS Rating Bucket      Factor
AAA               I – Extremely Strong         0.008%

AA                   II – Very Strong          0.056%

A                      III – Strong            0.66%

BBB                   IV – Adequate            1.312%

BB                   V – Speculative           2.032%

B                 VI – Very Speculative        4.446%

CCC or         VII – Extremely Speculative     6.95%
Unrated               VIII – unrated           1.6%

           SCR credit risk = MV of exposure * duration * factor
     Solvency II – Reinsurance Implications

Reinsurance constitutes exchange of insurance risk
(primarily underwriting & accumulation) for asset risk:
  Asset risk carries a lower capital charge than insurance risk,
  thus reinsurance can be an effective way to manage
  regulatory capital needs
Factor based models do not distinguish between
proportion and non-proportional reinsurance
  Risk mitigating effect of non-proportional reinsurance
  compared to ceding of profits are reflected more adequately
  within simulation based models

    Effect of Reinsurance on Solvency Rules
Reinsurance provides:
  Capital relief in MCR (Minimum Capital Requirement) and
  SCR (Solvency Capital Requirement):
Rating of Reinsurers to be factored in -
  The higher the rating of a reinsurer the lesser capital is
  Increasing tendency to cover credit risk arising from
  reinsurance recoverables
   • Retrospective and prospective coverage reinsurance solutions
Concentration of Credit Risk
  UK FSA monitors annual premium ceded to one reinsurer
  (20%) and total recoverables from any one insurance group
  to not exceed 100% of capital resources

                     Risk Based Capital

Due to the diversification ability of the reinsurer, more capital is
freed up on the cedent’s side than is bound on the reinsurer’s side.
Therefore, the cost of assuming the risk is lower for the reinsurer
than for the cedent.

U.S. RBC Reinsurance Charge
10% charge for reinsurance recoverables.
  Rationale for the Reinsurance Charge
   • The apparently high charge on reinsurance
     recoverables was motivated by reinsurance
     collectibility problems contributed to several major
     insurance company insolvencies in the mid-1980s.
Criticism of the Reinsurance Charge
  Quality of Reinsurer:

    Types of Life Reinsurance

  Traditional           Spread or Lessen Risk
  Financial             Meets Financial Goals
  Non-Proportional      Catastrophe, Stop Loss
  Retrocession          Reinsurance of Reinsurance

  Transfers Business Permanently

     Reasons for Indemnity
Transfer Mortality/Morbidity Risk

Transfer Lapse or Surrender Risk

Transfer Investment Risk

Help Ceding Insurer Finance Acquisition Costs

       Reasons for Indemnity
Provide Ceding Company
 •   Underwriting Assistance
 •   Product Expertise
 •   Tax Planning
 •   Help Manage Capital and Surplus and/or RBC

Limit Adverse Effects of Catastrophic Events

Help Enter New Market

     Assumption Reinsurance

  Sale of a block of business
  Novation of a contract

Reasons For Assumption
  Raise Capital
  RBC Issues
  Help Ratings

       Alternative Risk Transfer
Techniques other than traditional insurance
and reinsurance to provide risk bearing
entities with coverage or protection :

    Finite Risk
    Contingent Capital
Established with the specific objective of financing risks
emanating from their parent group or groups :
      Single Parent Captive
          An insurance or reinsurance company formed primarily to insure the risks of
          its non-insurance parent or affiliates.
      Association Captive
          A company owned by a trade, industry or service group for the benefit of its
      Group Captive
          A company, jointly owned by a number of companies, created to provide a
          vehicle to meet a common insurance need.
      Agency Captive
          A company owned by an insurance agency or brokerage firm so they may
          reinsure a portion of their clients risks through that company.
          A company that provides 'captive' facilities to others for a fee, while
          protecting itself from losses under individual programs, which are also
          isolated from losses under other programs within the same company. This
          facility is often used for programs that are too small to justify establishing
          their own captive.

Two other types of insurance company which have developed
recently are special purpose vehicles (SPV) and segregated
portfolio companies (SPC):

      SPV - Although used extensively in the past
      for various financing arrangements, recently
      they have been used for catastrophe bonds
      and reinsurance sidecars.
      SPC - SPCs can be formed as a rent-a-captive
      facility to enable those companies who lack
      sufficient insurance premium volume, or who
      are averse to establishing their own insurance
      subsidiary, access to many of the benefits
      associated with an offshore captive.

Captives are becoming an increasingly
important component of the risk management
and risk financing strategy of their parent. A
number of reasons have been put forward as
the basis for the growth in the use of
  heavy and increasing premium costs in almost every line of
  insurance coverage.
  difficulties in obtaining cover certain types of risk.
  differences in coverage in various parts of the world.
  Inflexible credit rating structures which reflect market trends
  rather than individual loss experience.
  insufficient credit for deductibles and/or loss control efforts.

     Finite Risk, Defined
Usually multiple-year
Insured (or reinsured) pays significant portion
of the losses
Time value of money plays an important role in
transaction value for both insurer and insured
Relatively narrow band between potential profit
and potential loss to counterparties
Historically, long term budgeting and financial
reporting have been key considerations

Does the level of risk match the
   accounting treatment?
Crux of the issue because it impacts the
solvency of the cedent
Can’t always tell by the contract language
Need to review and challenge assumptions
underlying the cash flow models
Are there “side” agreements that undo the
initial risk transfer?

What is the right amount of risk
“significant” loss (10/10?)
  Both Underwriting and timing
“taking a drop of risk and putting in a
loan and calling it insurance is
problematic” (Robert Herz, Chairman of FASB)
No matter where line is drawn, products
will be designed to just get over the

     Risk Transfer
                    Red Flags
Provisions that require careful analysis:
 • Retrospective Premiums - Premium rate is adjusted based on loss
 • Sliding Scale Commissions - Commission rate is adjusted based on
       loss experience.
 • Contingent Commissions - Additional commission based on profit
 • Floating Retentions - Ceding company’s retention is adjusted based
      on the experience of the contract, last dollar paid contracts.
 • Accumulating Retentions - Aggregate covers
 • Loss Ratio Corridors / Loss Ratio Caps - Additional retention
      by the ceding company for a lower cost of reinsurance.

              Contingent Capital
Contingent Capital is an option which gives the
holder the right to raise capital from the option
provider at predefined terms upon the occurrence of a
pre-agreed event
     The capital injected can be ( subordinated )
     debt, preferred shares etc.
     Other than with a normal (“knock in” )
     option, the contingency is a different risk
     than that of the asset underlying the option.
     For example, triggers can be related to
     natural hazards, the financial market, the
     price level of certain commodities, the state
     of the economy etc.

       Contingent Capital
Immediate and (long) term availability of
capital at predefined costs after
“catastrophic” or unexpected events.
Prevents from having to retain large liquid
sources of capital on the balance sheet (“off
balance sheet reserve”)
Balance sheet protection against possibly
difficult to insure risks. Reduces on-balance
sheet capital without increasing overall risk
profile of company (helps e.g. solvency ratio,
capital adequacy )

Such activities expose insurance companies to systematic or
financial market risk; that is, the risk of asset and liability
holdings being affected by external (to the company) market
factors. For the insurance sector, the most important financial
market risk factors are:
      Risk that interest rates may move up or down and thus affecting the
      value of assets and liability holdings.
      Basis risk which occurs when asset and liability portfolios are not
      matched and therefore interest rate changes will have a different affect
      on their total values.
      Inflation risk affects the value of asset holdings and may cause
      consumers to switch away from insurance products unless returns
      compensate for reduced purchasing power.
      Foreign currency risk which occurs when investments or assets are held
      in a currency which devalues relative to the home currency.
      Movements in stock prices, which means that the value of investments
      in stock markets affect the ability of insurance firms to pay out
      competitive rates of return to their policy holders.

There are four major derivative instruments:
   Forwards are contracts negotiated over the counter between
   two private parties. They involve the obligation to either buy or
   sell an underlying asset at a prespecified price and date in the
   future and are privately negotiated between two parties. They
   have the advantage of being highly flexible with regard to terms
   and conditions. However, they have the possibility to provide
   counterparty credit risk and low trading liquidity because of
   non-standardised negotiated terms.
   Futures contracts also involve the obligation to buy or sell an
   underlying asset at a prespecified price and date in the future.
   Unlike forwards, they are standardised with regard to delivery,
   quantity, and quality. They are listed and traded on formal
   exchanges in which the clearing house manages and
   coordinates all trades and guarantees delivery or settlement of
   the contract. Moreover, they require maintenance margins that
   are settled daily by the clearing house, thus, virtually
   eliminating credit risk. Consequently, such contracts generally
   provide high trading liquidity.

              Derivativestwo participants who
Swaps are private contracts between
agree to exchange their different cash flows that might arrive in
the future. A common example is an ‘interest rate swap’,
whereby the parties agree to exchange the cash flows arising
from fixed and variable interest rate payments on specified
principal amounts.
Options provide the buyer the right, but not the obligation, to
buy or sell the underlying asset at a pre-specified time and price
in the future. Options have a number of characteristics that are
similar to an insurance contract. For the purchaser of a call
option returns on the upside are unlimited.
   For example, a contract to buy stock at $100 will be invoked if the
   stock is trading for any amount greater than $100 at the expiration
   of the contract. However, on the downside the loss is limited to the
   price of the call option. This call option contract protects the holder
   against price rises that will potentially occur in the future and is a
   similar payoff to taking out insurance that is conditional on a
   specified event occurring (such as flood). On the other hand, the
   writer of the option undertakes to cover the call upside risk (or
   downside for a put option) in return for the price of the written
   option. This is a similar position to the writer of an insurance

Securitization of insurance risks enables
insurers to transfer their insurance risk
directly to investors in the capital markets:
    Insurance company transfers
    underwriting risks to the capital markets
    by transforming underwriting cash
    flows into tradable financial securities
    Cash flows (e.g., repayment of interest
    and/or principal) are contingent upon
    an insurance event / risk
 Factors Affecting Insurance Securitization

Recent catastrophe experience
  Reassessment of catastrophe risk
  Demand for and pricing of reinsurance
  Reinsurance supply issues
Capital market developments
  Development of new asset classes and
  asset-backed markets
  Search for yield and diversification
Restructuring of insurance industry
 Possible Reasons for Securitization
  Risk of huge catastrophe losses
  Would severely impair P/C industry capital
  Capital markets could handle
  Catastrophe exposure is uncorrelated with
  overall capital markets. Thus, uncorrelated
  with existing portfolios.
  Diversification potential
Potential Success of Insurance
Difficult to understand
  Capital markets
  Insurance markets
Separation of insurance and finance
functions in many companies
Information and technology
Difficult to price
Expensive (vs. cat. reinsurance market)
Legal / tax / accounting issues

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