Risk Management

Insurance Risk V/S Altenaytive Risk Transfer
Birds view of Risk

There is no single, universally accepted definition of the word risk, and this means that it is used to describe many different situations. For example, in the insurance industry it is frequently used in reference to an insured object (a house, factory, ship or car); or to the perils such as fire, storm, or collision to which that object is exposed; or to a hazard or set of hazardous conditions which may cause or exacerbate a loss (for example, the use or storage of flammable materials, perhaps near to a source of heat); or to the probability of a loss occurring. Used in the context of risk management, it is the last usage which gets nearest to an acceptable definition of risk: a phenomenon closely associated with uncertain events. We often find the terms "risk" and "uncertainty used interchangeably. However, a distinction needs to be drawn between the two. Risk is often thought of in terms of chance (or probability) of loss. Uncertainty falls into two broad categories. There are those for which the probability of occurance is calculable either on a priori grounds or through the statistical analysis of a series of similar events that have occurred in the past. The remainder do not lend themselves to such measurement either because their occurrence follows no discernable pattern or because they are unique events. Professor Frank Night called the first group risks, whereas the latter he described as uncertainties,in his book Risk ^uncertainty and profit. John Maynard Keynes a well known economist considers that the element of surprise is an important element of a situation of uncertainty. The importance of uncertainty arises from its influence on the process of decision-making of individuals, businesses as also society. While risk is a state of nature, uncertainty is a state of human mind.Jt is therefore possible to consider a situation risky if a number of outcomes is possible and the actual outcome that materializes is not known in advance. Thus, risk is defined as the relative variation of the actual outcome from the anticipated or expected outcome. For instance, for a manufacturing firm, the development of a new product is risky as the profits from the sale of the product in the market are uncertain before the actual sale. Likewise, the development of a new drug by a pharmaceutical company is characterized by risk because of as the range of possible outcomes with regard to the market reception for the drug. 2
Insurance Risk V/S Altenaytive Risk Transfer The concept of risk is to be distinguished from the terms 'peril' and 'hazard'. 'Peril' is defined as the cause of loss. Perils that cause damage to property include theft, burglary, fire, hailstorm, windstorm, lightning and earthquakes. An example of peril is: if Rama's car is damaged in a collision with Ramesh's car, collision is the peril or cause of loss. A condition that creates the chance of loss or increases the chance of a loss is termed a 'hazard'. Three major types of hazards are usually distinguished. a. b. c. Physical hazard Moral hazard and Morale hazard
Physical hazard : A physical condition that heightens the chance of loss is called physical hazard. A large number of examples of physical hazard from our daily life can be cited, such as defective electrical wiring in a cinema hall which increases the chance of fire, bad and poorly maintained roads that increase the chance of motor accidents and defective locking system on the main door of an apartment that increases the chance of theft. Moral Hazard : Moral hazard is a condition characterized by defects in the character of an individual such as dishonesty that increases the frequency of loss or severity of loss or both. Moral hazard is a common occurrence in insurance and is not easy to control. Examples: making a fraudulent insurance claim, submitting an insurance claim for an inflated amount and setting fire to an insured godown stocked with inventory. With a view to controlling moral hazard, insurers take a number of steps such as careful underwriting practices, and by including a number of provisions in the insurance policy such as exclusions, deductibles and riders. Morale Hazard : Sometimes, a distinction is drawn between moral hazard and morale hazard. While, as defined earlier, moral hazard refers to a deliberate dishonesty resulting in increasing the frequency or severity of loss, morale hazard
Insurance Risk V/S Altenaytive Risk Transfer refers to carelessness or indifference to loss because of the presence of insurance. Examples include leaving the main door of a house open to make entry of a burglar easy, leaving car keys in an unlocked car door, and carelessness in regard to maintenance of health because of existence of a health insurance policy. Such careless acts increase the chance of loss.
Classification of Risk
Risks are classified in many different ways. Four ways to classify risks are given below:
Pure & Speculative Risk

A traditional classification of risk distinguishes between pure risk anxl speculative risk. Pure risk exists when a situation is characterized by uncertainty as to whether or not loss will occur. Pure risk does not admit the possibility of gain but only potentiality for loss. Examples of pure risk include prospect of untimely and premature death, likely damage to property by flood, earthquake, lightning and fire and catastrophic medical expenses. Speculative risk is present when an event can result in either a gain or a loss or status quo. Examples of situations involving speculative risk include individual's decisions to buy shares\or investment decisions of business firms or business ventures and investing in real estate. Three prime reasons warrant the distinction to be drawn between pure and speculative risks. While insurance companies basically insure pure risks, speculative risks are generally not considered insurable, barring a few exceptions like institutional portfolio investments. Second, while the law of large numbers can be easily applied to pure risks, speculative risks are not easily enable to the application of law of large numbers which facilitates prediction of future loss experience by insurance companies. A notable exception is the efficient manner in which casino operators apply the law of large numbers to the speculative risk of gambling. Third, while the society is harmed by the presence of pure risk when a loss occurs, society may benefit despite the occurrence of loss from a speculative risk. There is no doubt that the society does not benefit from the loss arising from a pure risk situation. A company developing a new technology to produce computers at a lower cost may benefit the society as a whole while some existing computer companies may become bankrupt because of this development, is an example in this regard. However, it is possible that in some situations both pure and speculative risks may exist. Likewise, some of the speculative risk decisions which are motivated by earning profit might have an impact on pure risk exposures. For example, developing
Insurance Risk V/S Altenaytive Risk Transfer and introducing a new product into the market by a manufacturing firm mainly entails speculative risk. In addition, the decision might also lead to a pure risk exposure such as potential product liability.
Dynamic & Static risk

Another classification of risk cutting across pure and speculative categories is the division into static risks and dynamic risks. Dynamic risks arise from the changes that take place in every society, that is, economic, social, technological, environmental, and political changes. Static risks are those that would exist in the absence of such changes. Dynamic risks are closely related to the speculative risks whereas most pyre risks are examples of static risks. Yet another classification of risk that is attempted is the following : Fundamental and Particular Risks As we have discussed earlier the distinction between pure and speculative risks, we may now take up for discussion the second major category of risk, namely fundamental and particular risks. Fundamental risks &re those which affect the whole of society or a major part thereof, such as uncertainties arising out of the economic or political system or natural catastrophes such as earthquakes and floods. They are impersonal in both cause and effect. Particular risks on the other hand affect mainly the individual or firm and arise from factors over which he may exert some contro/.Jhls distinction assumes importance as a social insurance and government insurance programmes or government subsidies may be necessary to deal with situations of fundamental risk. A particular risk is a risk that does not affects the entire community or groups of persons within the economy but affects only individuals. Examples such as bank robberies and car thefts affect the particular individuals or firms experiencing such losses. In contrast, a fundamental risk is a risk that affects a group of persons, or the entire economy. Risks such as natural disasters, war, high inflation and cyclical unemployment are some of the examples of fundamental risk. The recent Gujarat earthquake is another example point.
Subjective & Objective risk

A fourth classification of risk that we come across is dependent upon the criterion whether it is based upon the state of mind of an individual or it is precisely observable -subjective or objective risk. If the type of risk is more precisely observable and therefore measurable it is referred to as objective risk. In this type of risk, the actual experience may differ from the one expected. On the other hand, subjective risk basically emanates from a person's is state of mind or mental attitude. As a particular individual's perception of risk in a particular situation may be different from another, there is a possibility of making different decisions by two individuals in a situation that is seemingly identical. It is clear, therefore, that it is not sufficient to know the degree of objective risk. We have to also learn the attitude towards risk of a person who is acting on the basis of this knowledge. Individuals, businesses and societies are increasingly subject to risk and have to cope with it. Bhopal and Chernobyl (and recently, the Tsunami tragedy) illustrate how a single event may impose serious harm on societies. The management of risk has become considerably more important today than in the past. In most cases, our concern about risk relates ultimately and exclusively to individuals, whether as members of families, as owners, employees, or customers of businesses or as citizens*.A classification of different sources of risk is suggested which consists of Operational / internal risk, Financial Risk and Strategic Risk OPERATIONAL / INTERNAL RISKS: Operational / internal risks are those that arise from the operations of an organization or firm the activities of an individual. This type of risk is associated with failures of a system, human errors, inadequate procedures and controls and deficiencies in information systems. We may observe that individuals or organizations have some control over them. Examples of this class of risks include automobile accidents, strike-by employees of a firm and work stoppages, loss of damage to property as a result of fire, uncertainty about legal liability arising from production of defective or faulty products.
Insurance Risk V/S Altenaytive Risk Transfer FINANCIAL RISK: Financial Risk arises from individuals or organizations using financial institutions or ownership of such instruments. Financial risks are those occasioned by changes in interest rates, transactions involving foreign currency, shareissues, extension of business credit and employment and use of derivative instruments. They are primarily external to the individual or business. Therefore, this type of risk is not under the direct control of the individual or business. Individuals making investments, or borrowing funds from a finance company to buy a car or a residential house or a firm extending credit to its customer are some instance of financial risk. STRATEGIC RISK : Strategic risks basically arise from economic, demographic, political, technological and social factors that impact on individuals and businesses. A number of examples are cited such as consumer preferences, legal system, regulatory environment, terrorism and global warming. While it is not possible to control these factors and risks involved, it is within the capability of individuals and businesses to take steps to mitigate the deleterious effects of such risks. It is necessary to state that such classifications are largely arbitrary and counterproductive in that different types of risk do not call for different ways of managing them. Inact, all risks, however classified, are subject to the same approach and analysis of risk management. The ever broadening of the scope of risk management in modern times lends support to the futility of such classification of risks. While historically management of risk has been concerned primarily with situations whose outcomes involves losses only, individuals, businesses and government have come to realize that this fragmented approach to risk management is not efficient and what is needed is a comprehensive, an integrated or holistic approach encompassing all risk exposures which an individual or organization faces. For instance, corporates face a whole range of risks such as financial, operational, business and insurable. The source of risk is not so important as the impact of the risk exposure. Corporate earnings are disrupted, funding of new investments might be adversely affected and even a threat of bankruptcy of the firm may develop whether the risks are financial or insurable. Furthermore, it may not be feasible to conveniently isolate the contribution by each source of risk as the risks might not just
Insurance Risk V/S Altenaytive Risk Transfer add up. The risk tolerance level of a firm in regard to any particular risk is influenced largely by its current level of exposure to other risks. A more elaborate discussion of integrated risk management approach will be found in a later chapter. Risk management, according to Bernstein is the dividing line between modern times and the past. According to him: "The ability to define what may happen in the future and to choose among alternatives lies at the heart of contemporary societies. Risk management guides us to choose over a vast range of decision-making, from allocating wealth to safeguarding public health, from waging war to planning a family, from paying insurance premiums to wearing a seat belt, from planting corn to marketing cornflakes". HISTORICAL DEVELOPMENT OF THE CONCEPT OF RISK The first notable step in providing a formal and mathematical basis for the theory of probability was taken in 1654 by two French mathematicians Blaise Pascal and Pierre de Format to resolve a puzzle that had been teasing mathematicians as well as gamblers for over 1 50 years. The puzzle is : How are the stakes between two players in a game of chance is to be divided if the game is stopped before it comes to an end and one player is ahead of the other. The solution they suggested was that the two players share the stakes on the basis of the respective probability that each would win the game. Though the response of Pascal and Fermat was to a puzzle in a game of chance, their demonstration of the method of calculating the probability of each player's was a vital intellectual breakthrough. In the next fifty years after 1654, a number of innovations and discoveries that are useful as building blocks with the development of tools of risk measurement were developed such as statistical sampling, statistical significance, various applications of probability theory to practical problems and early efforts for defining normal distribution and standard deviation. The three other major components of the science of risk management as we understand today namely the notion of utility and the concepts of regression to the mean and diversification have been developed in course of time. The chronology of risk as suggested by Bernstein in his article "The Enlightening struggle against uncertainty is given below". CHRONOLOGY OF RISK : 9
Insurance Risk V/S Altenaytive Risk Transfer 1654 French Mathematicians Blaise Pascal and Pierre de Fermat analyze
games of chance, providing for the first time a formal and mathematical basis of the theory of probability. 1662 English merchant John Graunt publishes tables of births and deaths in
London using innovative sampling methods. He estimates the population of London the technique of statistical inference. 1687 Edward Lloyd opens a coffee house in Tower Street, London. In
1696 he launches Lloyd List, giving information on aspects of shipping from a network of Eurporean correspondents. 1696 English mathematician and astronomer Edward Halley shows how
life tables can be used to price life insurance at different ages. 1713 Swiss mathematician Abraham de Moivre proposes the normal
distribution, the pattern in which a series of variables distribute themselves around an average, from which he also derives the concept of standard deviation. 1738 Jacob Bernoulli's nephew Daniel introduces the idea of utility :
decisions relating to risk involve not only calculations of probability but also the value of the consequences to the risk taker. 1885 English scientist Francis Gallon discovers regression to the mean, the
tendency of extremes to return to a normal or average. 1894 In Theory of Games and Economic Behavior, US academics John
Von Neumann and Oskar Morgenstern apply the theory of games of strategy (in contrast to games of chance) to decision making in business and investing. 1952 US economist Harry Markowitz demonstrates mathematically that
risk and expected return are directly related, but that investors can reduce the variance of return on their investments by diversification without loss of expected return. 1970 US academics Fischer Black and Myron Scholes publish a
mathematical model for calculating the value of an option.
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Insurance as Risk Transfer

Considered purely from a risk financing point of view, insurance provides a means for handling risks with a low probability of suffering a large loss which an organisation cannot afford to retain itself, even on an internal funding basis. In principle, taken over a sufficiently long period, a policyhol-der will always pay for his own losses plus an additional sum to cover the insurer's administration costs and profit. This fact can be seen from the basic premium equation (for simplicity investment earnings on the insurance funds are ignored): P = (p x c) + L, where P = annual premium p = probability of one or more losses during a year c ^ the average size of losses that occur L= the premium loading to cover expenses, contribution to reserves and profit. The first part of the premium (p x c) is the risk premium which is the insurer's estimate of the policyholder's annual loss expectancy, that is, the annual expected average claims cost. Provided the risk premium is a correct estimate of the loss expectancy, over a very large number of years tptal risk premiums will equal total claims, and'in addition the policyholder will pay the premium loading. Policyhol-ders are willing to pay such a price for insurance because the insurer assumes responsibility for the fluctuations in loss experience from year to year. The policyholder is able by means of insurance to spread his risk costs more evenly over time; instead of being exposed to the risk of incurring a possibly financially crippling loss in any one year, he undertakes to pay a known or determinable premium for which he can budget. It can be demonstrated that only people who are averse to risk will purchase insurance, and, as explained in chapter 2, even then the price which someone will be prepared to pay in excess of the loss expectancy transferred to the insurer will depend
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Insurance Risk V/S Altenaytive Risk Transfer upon how risk averse he is, and this is an attitude of mind, that may -vary according to the potential size of the loss. Such behaviour can be observed in the tendency of people and-organisations to insure only those risks with loss potentials too large to be absorbed without causing severe financial difficulties. If the risk has a very low loss potential, then the premium-required to cover the insurer's administration costs makes insurance uneconomic: no one seeks insurance against shoe laces breaking! In the case of risks with high frequencies of occurrence and low loss severities, again insurance is unlikely to be regarded as economic: not only will the losses lie within the organisation's own capacity to absorb, but also insurance becomes little more than a 'pound-swapping' exercise with the insurer paying losses and recouping their cost, plus his administration costs, through the premiums charged. It is when loss experience is subject to large fluctuations from year to year, and maximum losses may exceed a tolerable level(in other words, there is a significant downside risk), that it becomes worthwhile to pay for insurance, including the insurer's premium loading. What constitutes a small loss is a matter of individual circumstances. 'Small' is relative to each organisation's financial situation, including its wealth, cash flow, and other factors which were considered in Lesson 8. Allowing for such facts, the grounds on which a decision to buy insurance will be taken can be summarised as: the potential size and frequency of losses: if there is such a high frequency and low severity of losses that they can be predicted with a very high degree of certainty, there is no risk and no point in insuring. Insurance is best suited to risks with low frequency and high loss severity. the size of the premium loading: the larger the loading the more incentive an organisation will have to retain its own risks. the value that the organisation places upon financial certainty.
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Limitations to the Benefits of Insurance

There are limits to both the availability and the benefits of insurance as a method of risk transfer, the most notable being the following. Not all risks are insurable. In order that an insurer can offer insurance against a particular type of risk, ideally the following conditions are necessary: there needs to be a large number of exposure units which are (i) sufficiently alike, and (ii) independently exposed to risk, to enable insurers to use past loss data to predict future loss experience, and to acquire a reasonably stable underwriting portfolio not exposed to an accumulation of losses from one event; losses need to be fortuitous so far as the policyholder is concerned, and he should not be in a position to profit from the occurrence of the insured event; losses should be capable of measurement in monetary tertms and definite in amount; loss potentials should be sufficiently large to make insurance worthwhile; premiums should be economically feasible for both parties. Insurers would do little business if they were prepared to offer insurance only for risks which fully met all of the above conditions, so that in practice there is an illdefined boundary between insurable and uninsurable risks. Uncertainty as to premium costs. The larger the organisation the more unlikely it is to accept that its premiums should be based on standard rates for particular classes of business. Instead, it will seek to obtain premiums that are related directly to its own loss experience, particularly if it believes that its standard of risk control and so its loss experience is better than average. If insurers agree, then part of the cost of adopting some form of experience rating will be loss of certainty as to premium costs. The fixed premium payable
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Insurance Risk V/S Altenaytive Risk Transfer At the inception of each period of insurance may be replaced by a deposit premium subject to later adjustment. Depending upon the particular type of preniium rating employed, the deposit premium may itself be dependent upon loss experience over the preceding three or more years, and a series of adjustment premiums may be payable over several ensuing years until all claims forming part of the premium calculation base have been settled. The only control over fluctuations in premium costs will then be the agreed premium adjustment limits. Even for insurances that are not experience rated, premiums may be subject to adjustment at the end of the period of insurance due to changes in exposure during the year. Liability insurances, for example, are commonly rated on the basis of wage roll or turnover during the year. Taken over the longer term, premiums for all insurances are subject to change in line with loss trends. Insurance rarely provides perfect compensation for losses. Even ignoring the problem of sentimental value for which there cannot be any objective measure, only rarely is it possible to place a precise monetary value on a policyholder's loss. Take the case of property damage where the value, its net realisable vaule, or its economic value measured as the net present value of its future contribution to earnings. As a number of cases that have come before the courts have shown, the differences between those three values can be very large. The best measure of the loss incurred will depend upon circumstances and intentions; for example, if a policyholder was on the point of disposing of a car when it was stolen the best measure of his loss may be its trade-in price, but if he had intended to continue to use it, then the second-hand buying price would be more appropriate. Even when property is repaired, questions of betterment arise. Indemnity means restoring a policyholder to his pre-!oss financial position, but-even full insurance may not achieve that objective. A product liability insurance that pays in full an injured third party's claim for damages, plus legal and other expenses incurred, will still leave the plicyholder uncompensated for: costs incurred in, and management time diverted to, assisting insurers in the handling of the claim (for example, giving of evidence, etc.);
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Insurance Risk V/S Altenaytive Risk Transfer loss of goodwill, and so of sales, due to adverse publicity associated with the claim. Similarly, business interruption insurances can afford no protection against a permanment loss of market share to competitors following a prolonged stoppage of work and so of sales due to major fire damage.
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Alternative Risk Transfer

The term Alternative Risk Transfer (ART) was first coined in US since a decade ago to describe various forms of self insurance like Captives, risk-retention groups, which were formed by corporates to circumvent the accepted methods of dealing with risk-exposures namely buying insurance policies. But over years the concept of ART has acquired altogether new concatenation and has made its comeback into mainstream corporate risk management practices with renewed vigor and with the active participation of both the insurance and corporate players alike. To start with ART is a concept representing a broader approach to risk management than that traditionally exhibited by the conventional Re/Insurance market. ART basically involves usages of products and combination of products from i) Conventional (re) insurance market like usage of self-insurance, captives, financial guarantees ii) Banking sector usage of facilities like letter of credit, loan, project and structured financing iii) Capital market and involves usage of instruments like bonds, derivatives, securitization etc when you look at the concept of alternative risk transfer (ART), the word "Alternative" is quiet misleading term because it gives a meaning that ART products offer solutions other than those offered by conventional insurance market, which is not true, rather they complement insurance products by tackling risks or part of risks faced by corporates that conventional insurance market may not be willing to accept. Similarly the word "Risk Transfer" is also a misnomer because products under ART are often risk financing instruments containing little or no transfer of risk. ART products and their related activities are collectively referred to as ART market. This market continues to grow in volume and at the same time new innovative instruments are being introduced in the market every year with new features to tackle risk. With the increased sophistication of risk managers, and the 17
Insurance Risk V/S Altenaytive Risk Transfer convergence of actuarial sciences, financial mathematics and capital market innovations paved way for emergence of sophisticated risk reduction products for which ART market is providing the launch pad. Added to this there was a fundamental shift in the thinking process of management form a tactical to strategic focus for risk protection and minimization. Over years, the conventional insurance market has failed to come up with new product/process innovation and is lacking speed and adaptability to meet the ever changing risk needs of corporates and risk mangers and corporates started questioning about the value of insurance products and their inability to recoup major catastrophic losses and lack of flexibility in the products of insurers had also fuelled the growth of ART market and all these contributed to the emergence of ART market. The role of brokers, bankers and reinsurers is also commendable, because of their interest, and eagerness to invest in new products and take additional risks in financing new instruments has a very tremendous effect on development of ART market.
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The "Four C's" of ART

To better understand this market and its prospects for growth we need to look at the "Four" "Cs" of Alternative Risk Transfer: the Characteristics of ART when compared to conventional (re)insurance; Capital and the most efficient use of it; the Convergence of the insurance and capital markets, allegedly the real driver behind the ART market and, finally, the Constraints on the growth of the ART market and the likelihood of their removal.
Characteristics
ART is not a product : it is a concept representing a broader approach to risk than that traditionally exhibited by the conventional (re)insurance market and involving products and combinations of products from the conventional (re)insurance market (self-insurance, captives, contracts of indemnity, financial guarantee) banking (letters of credit, loan, project and structured financing) capital markets (bonds, derivatives, securitisation) and corporate markets (put and call options). By comparison with the conventional (re)insurance market there are a number of characteristics common to most variants of ART, although not necessarily present in each transaction: Multidisciplinary ART transactions frequently involve a multidisciplinary team in order to secure the optimal solution for the client's problem. This will involve members experienced in (re)insurance products and pricing, capital markets, accountants, risk modellers' actuaries, tax advisers and lawyers to help structure the transaction and create enforceable documentation. Multiyear Risk is assumed over longer time horizons, multi-year transactions are common in contrast to the traditional "annual renewal" approach of the conventional market.
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Insurance Risk V/S Altenaytive Risk Transfer Multiline ART structures can incorporate both the risk specific approach which characterises the conventional market e.g. indemnity against property/casualty losses, and also a more "holistic" or integrated risk management approach bundling a broad range of specific losses and, increasingly, risks such as operational risks not hitherto considered insurable. Mulitrigger Single, double and treble triggers help specify the risk being transferred and reduce both premium payable and the risk of exposure borne by the ultimate risk carrier. Multiparty Conventional covers are bilateral contracts between the insurer and insured or the insurer and reinsurer. ART transactions are often multiparty involving contractual relationships between not only the initial loss bearer and ultimate risk carrier but may also include derivative transactions with counterparties, and arrangements with trustees and others depending upon the structure and the nature of the transaction. Multijurisdiction The search for the most certain regulatory and transactional environment leads to the use of a number of different jurisdictions and laws in order to achieve bankruptcy remoteness and certainty in legal, regulatory, tax, and accountancy issues.
Capital
The driver behind ART and alternative risk financing ("ARF") is access to capital. Hitherto corporates and insurers were able to transfer the traditional classes of insurance risk by reference to only one source of capital: that provided by the insurance industry. Corporates and insurers traditionally accessed capital from other sources for different purposes: from shareholders for equity, from banks for working capital or the acquisition of new business and from the capital markets for hedging
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Insurance Risk V/S Altenaytive Risk Transfer purposes. ART and ARF is about securing the optimal use of capital from the different available sources instead of from just one source. ART permits arbitrage between the pricing and the products available in the (re)insurance, banking and capital markets, each with their different cycles, appetite for risk and costs of capital driven by different regulatory requirements.
Convergence
It is a widely held belief that the future of ART is wholly dependent upon the convergence of the three financial services sectors that have traditionally been separately regulated: (re)insurance, banking and investment. In common with much else that is said about ART this is only half true. If convergence means identical regulatory requirements for each of these three industries this would inhibit the growth of the ART market because it is in the arbitraging of the different costs of capital in each sector, the use of their different products and in an appreciation of their different appetites for risk that the strength of ART lies. What is required is not convergence in this sense but deregulation allowing entities from the three separate financial services sectors to secure vertical integration and the economies of scale associated with that integration. At present Europe, including the UK, is deregulated in this latter sense.
Constraints
Looking to the year 2000 and beyond, what then are the key constraints on the growth of the ART market? Or, put another way, what prevents the alternative market from becoming mainstream and conventional? Price is often quoted as the hard line constraint. As long as rates in the conventional (re)insurance market are soft the received wisdom is that growth in the ART market is stalled. This view is not without foundation. But price is not necessarily the key issue where more broadly structured ART products are under consideration with no equivalent in the conventional market or which incorporate conventional market products. Examples would include structured
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Insurance Risk V/S Altenaytive Risk Transfer finance, corporate finance and project finance transactions where conventional insurance may be a component alongside capital markets' risk transfer and risk financing techniques. Solutions drawing on a combination of insurance and capital markets products offering broader transfer or financing opportunities than those available from the conventional market alone will be less price sensitive and may represent the way forward for ART in a soft conventional market. When compared to the transactional costs of traditional insurance the higher transactional costs of bespoke alternative risk transfer and financing transactions have until recently restricted their use to high value transactions capable of bearing these increased costs. It is for this reason that the focus of transactions has been on the higher value end of the market. As more ART deals are done so the number of templates and models increases, producing a return on the heavy research and development involved in early ground breaking transactions. The ART market in the year 2000 and beyond will have to overcome a number of regulatory hurdles. Whether imposed by insurance regulators or statutory accounting treatment. Witness the debate surrounding the introduction in the US of Financial Accounting Standard 133, Accounting for Derivative Instruments and Heading Activities scheduled to take effect in the year 2000. The market generally drives the regulatory debate and level of activity amongst regulators to facilitate ART transactions is remarkable. A number of European countries are changing their laws to permit securitisation of assets not backed by the income stream from mortgages. Regulatory constraints and the absence of regulations facilitating certain types of transactions certainly represent an inhibitor of the growth of ART yet there are encouraging signs that they are being addressed by key regulators in a constructive pro-integration manner.
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Top Five Myths of the Alternative Market

One of the single most influential changes in the insurance industry over the past twenty-five years has been the emergence and growth of the alternative market. Leading experts estimate that this segment represents more than one-third of the U.S. commercial property/casualty market, approaching $70 billion annually. Myth #1 "Of course everyone shares a common understanding of the term alternative market!" Originally, the term alternative market was reserved for those commercial entities that had chosen to finance substantial portions of their property/casualty risks through their own balance sheets after years of transferring virtually all of these risks to the traditional insurance industry. Deductibles and other financial instruments used to fund highly predictable levels of risk had been popular for decades. In fact, there were actually over one thousand captives worldwide already in existence in 1980. It was not until the mid-1980s, however, that insureds were motivated to create more formal financing vehicles to address serious affordability and availability issues. The motivation for self insurance progressed beyond mere cost-efficiency to, in many cases, a means of economic survival. There was no single moment when the era of self insurance became the age of the alternative market. (No need to search for the "missing link" risk manager.) Rather it was the gradual, yet significant, growth in the economic influence that this constituency wielded that "created" the alternative market. Brokers, TPAs, claims adjusters, reinsurers and other segments of the industry that had previously worked almost exclusively through the traditional primary insurance industry, now saw the opportunity to service these risks directly. This market segment, driven by urgent financial incentives and fed by readily available resources, grew quickly. Beginning in the late 1980s, in response to the need for significant riskbearing capacity in the insurance industry, financial reinsurance and capital market products were developed. These products grew in popularity and came to be known as alternative risk financing or alternative risk transfer. The term alternative, in this 23

TODAY THE ALTERNATIVE MARKET HAS BROAD REPRESENTATION FROM A WIDE CROSS SECTION OF RISKBEARING ORGANIZATIONS
instance, was intended to differentiate these products from traditional insurance policies, reinsurance treaties and facultative certificates. As
these offerings have proliferated, the marketplace where these sophisticated financial engineering or capital market programs are sold has become known as the alternative market. Interestingly, traditional primary insurers and reinsurers are just as often the buyers of these alternative products as they are sellers. A brief review of any risk management periodical today reveals that there is no universally understood definition of the alternative market. This is particularly vexing since the influence of this market segment is so great. Based on an historical perspective, it would seem logical to propose that alternative market refer to the marketplace for those entities that seek risk transfer and risk retention solutions outside the traditional insurance industry, and reserve alternative risk finance to describe the products that differ from traditional insurance and reinsurance coverages. Myth #2 "The alternative market only consists of fortune 500 accounts." Although large corporate entities were the first to create formal risk retention programs, today the alternative market has broad representation from a wide cross section of risk-bearing organizations. For example, in the corporate arena, risk managers, brokers and other professionals who have significant Fortune 500 experience have now begun to apply their expertise to the upper middle market. Solutions previously unavailable are now studied and implemented by much smaller (though still sizable) entities. The alternative market is now a viable option for the Fortune 5,000 and beyond. An even more dramatic example of growth has been in the public and nonprofit area. Driven primarily by the availability crisis in the mid-1980s, this segment created a wide variety of individual and shared solutions out of economic necessity. Virtually every major governmental entity, religious society and educational institution has developed a formal risk-financing program. In addition,
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pooling and other jointly funded solutions have become acceptable risk management options to traditional insurance.
THE MERE INCLUSION OF A RISK RETENTION MECHANISM (NO MATTER HOW EXOTIC ITS LOCATION) WILL NOT NECESSARILY PRODUCE FAVORABLE RESULTS
In a similar way, many associations and other affinity groups have embraced the alternative market as a means of leveraging their members collective assets. This approach has proven valuable not only for risk financing, but also for developing loss control and other risk management techniques. It is for these reasons that risk retention groups, association captives and self-insurance funds now make up one of the fastest growing areas of the alternative market. A more recent phenomenon in this marketplace has been the proliferation of funding vehicles owned by managing general agents. While MGAs profit sharing arrangements have historically been tied to the commission portion of their underwriting contracts, the last decade has seen a significant increase in the creation of agency captives that allow true risk sharing between the insurer and the agent. These approaches are but a few of the examples that clearly demonstrate that the alternative market includes classes of risk well beyond the Fortune 500. Myth #3 "If a captive is involved, it clearly must be a sophisticated alternative market 25
program." One of the great fallacies prevalent in the marketplace today is the presumption that the mere inclusion of a formal risk retention mechanism (such as a captive) will provide all parties in a program with the implied cost-efficiencies of the alternative market. During the past few years of soft pricing, captive retentions have commonly dropped precipitously as the cost of risk transfer fell below the economic cost of retention. As a result, companies that used captives often retained very little risk. The captive/broker/insurer infrastructure that had been put in place during vastly different market conditions remained intact, but the parameters of the program changed dramatically. The ultimate risk bearers may have deluded themselves into thinking that financial interests had been appropriately aligned when, in fact, only more frictional costs had been introduced into what was essentially a fully insured program. The appeal of true alternative market partnerships with the insurance industry is that, ideally, financial interests will be mutually aligned. Financial relief brought on by aggressive risk management benefits both parties and ultimately should lead to lower retained losses and less expensive charges for risk transfer (insurance or reinsurance). If this financial incentive is out of balance, mutually beneficial results are unlikely. The substance of any risk-financing program is more important than the form. The mere inclusion of a risk retention mechanism (no matter how exotic its location) will not necessarily produce favorable results. Instead, both the risk manager and underwriter must design a program properly aligned to each others financial interests. Myth #4 "This market turn will be just like the last one, with enormous alternative market growth." Financial industry consolidation and strong economic growth would lead one to believe that redeployment of capital away from the underperforming insurance
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sector would be logical, even necessary. However, significant amounts of excess capital in this industry continue to temper any attempts to strengthen pricing in the face of well-publicized poor financial and underwriting results. There are a number of issues that highlight the difference between this marketplace environment and those of prior market corrections: Broker consolidation has given intermediaries the power to leverage risk bearers into much more buyer friendly arrangements. Over the past decade, the brokers have assumed a position of strength in the medium-to-large commercial risk marketplace through buyer relationships that many risk bearers feel they cannot achieve themselves. Insurers and reinsurers are thus reluctant to disrupt any one client relationship out of fear that it may result in the movement of larger pieces of business. Along with virtually every other segment of the worlds economy, the insurance industry has gone global. More well capitalized multinationals have entered the insurance market and some have demonstrated a higher tolerance to absorb adverse experience in any one country or line of business. While the theoretical appeal of portfolio underwriting has recently been tested (and higher profitability expectations should drive behavior in the very near future) the desire to gain and maintain market share continues to influence many pricing decisions. Ironically, an argument can be made that, while the alternative market was in large part born out of the violent market correction of the mid-1980s, its very existence is now a main contributor to the sluggish recovery. Change must be driven by a sense of urgency. But today, risk managers who have already created alternative market infrastructures can modulate the amount of risk they retain fairly quickly and easily. As a result, buyers do not perceive themselves in a position of total dependency on insurance. If the industry ceases to offer attractive economic terms for risk transfer, readily available alternatives can be accessed or expeditiously created by a cadre of professionals and organizations that did not exist twenty years ago. In addition, these facilities are now available to a broad array of buyersa much more
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diverse and sizable portion of the market than existed in the early to mid-1980s. We can expect the next market turn to be more of a series of corrections in specific geographical regions and lines of business, rather than an industry-wide escalation of prices. There is every indication that the insurance industry will return to profitability, but it will likely be a gradual ascent to a modest plateau rather than a mercurial rise reminiscent of prior cycles. And as an ever-increasing percentage of the sophisticated risk management community seek economic efficiencies by building, rather than buying capacity, the alternative market will continue its steady growth. Myth #5 "The alternative market only exists during a hard market." There is little doubt that the hard market conditions from 1975 through 1978 and 1984 through 1987 served as the sparks that ignited the alternative market explosion of the last quarter century. However, this marketplace has also continued to grow in size and influence during the intervening soft market years. The economic benefits of managing your own risk have been demonstrated innumerable times. An entire generation of risk managers and financial professionals have spent their careers in a business environment where significant risk retention is not the last resort, but rather the preferred option. Also, the mentality that the alternative market should be completely independent of the insurance industry no longer exists. In the early days of self insurance there tended to be animosity between the insureds (that often felt they had been abandoned without affordable or available coverage) and the insurers (that felt these clients had taken advantage of them during the soft market, but left when prices returned to adequacy). As a result, many programs were structured to eliminate any involvement with the insurance industry. Today, the advantages of insurer involvement in activities such as policy issuance, claims handling, loss control and risk transfer are clearly appreciated. In a sense, this transition marked the change from a self-insurance (independent) philosophy to a self/insurance (mutual
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cooperation) mindset. Soft market conditions and the alternative market are not mutually exclusive. The degree to which alternative market vehicles are used is obviously somewhat influenced by market insurance pricing. But with the financial benefits of managing your own risk, once alternative market solutions have been created, with very few exceptions, they continue to be used in some degree through soft markets, as well as hard. The uninterrupted growth in the number and size of captives and other funding programs over the past decade is clear evidence that this is indeed the case. Conclusion I hope my somewhat tongue-in-cheek treatment of this topic has proven to be partly educational and partly controversial. Having spent much of my career in the alternative market, I am amazed at how widespread some of these misconceptions have become. The alternative market (however you define it) will continue to grow in importance and influence both domestically and internationally. If we all speak in a more uniform context, we can be certain that our skills and expertise are applied effectively and efficiently.
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Advantages of ART market

The development of ART market has brought in many advantages to corporates and has opened new vistas in risk management and encouraged many corporates to venture into uncharted waters and experiment with their radical ideas and invest in new riskier business propositions whose risk is difficult to quantify. ART instruments has given ample opportunity to the entrepreneurs and corporates alike to hedge their risk exposures using various instruments available and experiment with new ideas. Some of the advantages of ART market are as follows: i) ART financing programs can be developed for insured (the party which takes insurance policy is called as insured) in virtually any industry from manufacturing to transportation to health care ii) ART helps in diversification of risk portfolio and reduces over insurance costs to corporates iii) Inclusion of financial market players allows easy accessibility of capital and this helps corporates in raising capital even for their risky ventures iv) Because of constant innovations and introduction of diverse risk hedging products like Insurance derivatives like catastrophic equity puts,risk securtization, etc has attracted big corporates for whom availability of these instruments paves way for hedging their risks. v) Long-term stabilization of total risk transfer costs is achieved with ART market instruments.
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ART Market around the World

North America
The US took the leading role in the area of ART market with many innovative solutions emerging form this market and has spread through out the world. The premium volume of conventional commercial insurance from 1975 to 1995 expressed as percentage of GDP, has been hovering in-between 2% to 2.5% of GDP, where as various forms of self-insurance have steadily gained importance in the last 20 years, and currently have an estimated volume of USD 128 bn and as become almost as important as conventional commercial insurance market of USD 158bn (source: Sedgwick estimates for 1997). The popularity of captives is also increasingly playing an important role in US market with more than 2050 captives set up by US corporates since 1997. The active participation of capital market investors has also provided thrust towards emergence of new instruments like insurance derivatives has boosted the availability of wide range of instruments in the ART market. Canada is also an important player in the ART market with as many as 145 captive formations taking place since 1997and takes a cue at the practices being implemented by its neighboring country USA.
Europe
ART market was well developed in UK, but relatively in the rest of Europe it is in it's infancy stages only. The number of captives set up by UK corporates account up to more than 600 since 1997 , where as the rest of Europe account for up to 445 captives. In Europe the role of capital market in ART market is still in its developmental stages, and is far less sophisticated as compared to US market. But experts say that with the introduction of single European currency Euro, in ART market. In Europe, London and Luxemburg are the key market places. a more proactive role of capital markets is expected to be witnessed in the coming years
Asia
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Insurance Risk V/S Altenaytive Risk Transfer In Asia if we look at the ART market, only Japan is considered to be as active player in the region. ART market is in its early stages in Asia, the reason attributed for this is the close interdependencies of corporates and insurance companies in funding their risk exposures and less prevalent of sophisticated risk management practices. But however slowly things started changing in Asia with the corporates in Japan aggressively having a re look at their risk management practices. with Japanese corporates recognizing that better risk management practices have a positive affect on their financial earnings, started importing latest risk management practices and this is paving way for development of ART market. As of now more than 65 captives were setup by Japanese corporates. Apart from Japan, other countries like Australia, Singapore have a ART market presence but not to that extend as of Japan. While the rest of Asian countries have to brace the ART market. However things started changing for good, with a lot of deregulation happening in many Asian countries insurance market and introduction of transfer of insurance risk to capital market investors, ART market is set to witness a upsurge incoming years in Asian markets.
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INTRODUCTION
A simplified explanation of risk Securitization would be that it enables the transfer of risk to the capital markets instead of transferring risk to insurance entities. The markets for insurance risk and capital are converging, prompting the development of Securitization products. The Securitization of insurance risk is a manifestation of the markets convergence. Insurance companies, that have traditionally held the advantage in bearing property and casualty risks, are transferring the hard-to-place risks on an aggregated or indexed basis to the capital markets. From the investors point of view, there are compelling arguments to include securities insurance risk in a diversified investment portfolio although whether this asset class will grow sufficiently in size and product range for investment fund managers to devote the necessary resources for portfolio inclusion remains to be seen. Furthermore, commodity, interest rate and equity risks, long the domain of the capital markets, are being offered as part of risk transfer packages by insurers. The Securitization of insurance risk is likely to be a permanent market function. Because issuers and bondholders act rationally, a transaction is completed only if the marginal benefits exceed the marginal costs for both parties. Therefore, an examination of the incentives to trade helps reveal the momentum behind the Securitization of insurance risk. This is another interesting application of Securitization concept. Trading in insurance risk is very common over centuries - insurance companies have a wellestablished re-insurance market. However, Securitization has made a significant difference to the way insurance risk is traded - by making it into a commodity and taking it to the capital market instead of the insurance market. Insurance risk Securitization relies upon the tremendous potential of capital markets in absorbing risk. Because global capital markets are so vast - publicly traded stocks and bonds have a total value of more than USD 50 trillion - they offer a promising means of funding protection for even the largest potential catastrophes.
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Insurance Risk V/S Altenaytive Risk Transfer Capital market insurance solutions also allow the industry to reduce counter party risk and diversify funding sources. Investors purchasing the securities can earn high-risk adjusted returns while diversifying their portfolios. The original concept of Securitization was to create securities based on financial assets, say, receivables on mortgage loans, auto loans, credit cards, etc. However, later innovation has extended application of Securitization to cover nonfinancial assets such as aircraft, buildings, and on the other hand, the same device has also been applied to securities risk, such as insurance risk, weather risk, etc. Although risk Securitization is still far from being a well-established finance tool its applications seem endless. Aside from the wide range of cover it can provide it can free up risk and capital from the balance sheets of insurers and re-insurers. It is a mechanism that allows investment banks to enter the insurance market without the need for substantial amounts of capital. It gives insurance brokers the opportunity to compete directly with insurers. Risk Securitization has increased the involvement of specialist consultants and law firms with the insurance industry due to the complexities associated with risk Securitization. Furthermore, it has generated a new line of business for rating agencies, namely assessing insurance risk. However, perhaps the most significant feature of risk Securitization is that corporations are now able to bypass the insurance industry and sell their risk exposure directly to the capital markets. These developments have resulted in increased competition in a market where price levels and profit margins were already under pressure. As one can imagine there are some practical difficulties associated with risk Securitization. Due to its innovative nature Securitization deals are relatively labor intensive at the moment and substantial amounts of documentation needs to be generated. This combined with the current "soft" insurance markets makes risk Securitization only cost efficient if large portfolios of risk exposure are securities. The "soft" insurance market is widely viewed as one of the main reasons why risk Securitization has not yet lived up to its potential. However, this "soft" market is not expected to last forever, in fact during 1999 several large catastrophes occurred potentially driving up re-insurance prices.
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Insurance Risk V/S Altenaytive Risk Transfer Even if the current "soft" market continues, it is unlikely to stop the development of risk Securitization. The history of the Securitization of assets and receivables reveals that investment banks were faced with a similar situation in the past. They wished to securities several assets held by different corporations, on their own these assets were too small to securities. So they developed a structure in which they could combine these assets making them cost efficient. A logical development in the future would be that such a structure will be devised for risk Securitization, which would make it more competitive in the current "soft" market. The current focus of risk Securitization however is on catastrophes and the risk exposure of large multinational companies. At the moment it would be virtually impossible for a corporation to securities its risk exposure without some level of involvement from the insurance industry. This overcomes initial fears held by the insurance industry about being completely bypassed. There will however be some form of convergence between the parties involved and roles are shifting within the insurance market. Risk Securitization and other alternative solutions are currently being restricted, not in terms of capacity but in terms of knowledge and skilled people available. If this trend continues and no efforts are made to systematically train people, insurers may resort to "buying" knowledge, meaning that they will recruit people experienced in alternative risk transfer (ART) from their competitors. Although this behavior is not uncommon with investment banks it would be a relatively new development for the insurance industry. As long as this bottleneck continues to exist, it will slow down the development of risk Securitization as well as the growth of the whole ART market. The insurance markets are now redesigning their existing distribution channels with the Internet in mind. This combined with the possibilities that risk Securitization offers has lowered the entrance barriers associated with the insurance markets. If such a lean and capital efficient insurer were to be created it would most likely focus on standardized insurance products with predictable forms of risk exposure. Car and life insurance would be some of the obvious choices because, firstly, claim behavior is to a large extent predictable but, more importantly, they have relatively high profit margins. Thirdly, most investors are familiar with these types of risk. Investment 36
Insurance Risk V/S Altenaytive Risk Transfer banks would be the obvious entrants although insurers themselves are also expected to establish these types of insurance companies. In summary, ART and especially risk Securitization has potentially placed all the market players in direct competition with one another. Until now everyone has more or less adhered to the traditional relationships within the insurance industry. Most of the risk Securitization deals done to date were either to demonstrate knowledge and/or for research and development purposes. It will be interesting to see what happens when the insurance market "hardens". If this happens banks, insurers and re-insurers can be expected to form alliances in order to gain or maintain market share by supplementing each others' knowledge. This development could ultimately even lead to convergence between the two industries. If insurance brokers remain active within the ART market, they will in some cases be in direct competition with banks and insurers. This could endanger their perceived level of independence, for them a dangerous development. Rating agencies would be the most likely candidates to fill this independent position by objectively assessing risk. Due to this potential threat of increased competition, another option would be that the insurance markets will permanently remain "soft". Only time can tell.
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The Economics of Insurance Securitizations

The practice of risk management has evolved significantly over the last 20 years and the development of derivative securities has played an important role. Insurers use derivatives to hedge against interest-rate risk, foreign exchange risk, and other risks. Insurers can hedge the risk that interest rates will change. Without hedging, the companys surplus bears the risk and the firm must collect additional premiums from policyholders to compensate the capital providers for such an unhedged risk. Entering into a futures contract to hedge this exposure is substantially less costly than bearing the risk with shareholder capital. Today insurers have a better understanding of options implicit in life insurance, annuities, and other insurance products. They value the risks explicitly and decide whether to hedge or to retain these risks. Hedging increases the demand for derivatives. An example of a property/casualty insurance risk security is a catastrophe risk bond. Financial engineers have created even more complex instruments such as double-trigger puts, in which the payoff of the derivative is contingent upon an insurance event, such as a catastrophe and a financial event, such as rising interest rates. In the case of the catastrophe risk bond, the transaction is straightforward, representing either an alternative to a layer of traditional catastrophe reinsurance or catastrophe coverage. The expanding role of risk management has not solved the problem of insufficient insurance capacity for certain lines of business. In the case of traditional insurance, shareholders of insurance firms bear these risks and expect a return on their capital that is commensurate with the degree of risk assumed. However, if alternative solutions to risk management problems (such as securitization) are more efficient in that the risk manager can hedge risk at lower cost than under traditional insurance methods and produce adequate returns to the risk bearers, then these alternative methods will replace the traditional ones. This is the basis of the economic argument in favor of securitization and derivatives in general. Specifically, Securitization results in a more efficient distribution of risk throughout the economy through both lower insurance costs and increased capacity. Additionally, due to market imperfections, insurance securitizations increase investment opportunities. Heres how the process works. 38
Structure of Securitization
The securitization technology applies to many kinds of risk, in addition to insurance risk. In asset and liability securitizations, the common structure typically involves four entities: retail customers, a retail contract issuer, a special purpose company, and investors. In the case of insurance risk bonds, the four entities are as follows: _ Individuals or firms who buy policies from an insurer; _ The insurance company that issues the individual policies (retail contracts) and buys rein urance from a special-purpose reinsurer (the special purpose company); _ The specialpurpose reinsurer that issues the reinsurance and sells bonds; _ Investors who buy the bonds. The investors initially pay cash to the special-purpose company and receive bonds in exchange. Subsequently, they receive coupons and principal, provided the insured event does not occur. If an insured event does occur, the special purpose reinsurer reimburses the insurer and the investors forfeit a portion of the coupon or principal depending on the bond contract. The transactions are structured so that the price of the bonds (paid by the investors) and the reinsurance premium (paid by the retailer) are adequate to cover the insured loss with certainty. Under such arrangements, the special purpose reinsurer cannot default on its insurance obligations. Therefore, there is no counterparty risk. (This implicitly assumes the instruments purchased with the proceeds of the bond issue are default-free.) The ability to eliminate counter-party risk is a major distinction between Securitization and traditional reinsurance. There is an obvious moral hazard problem associated with insurance risk securitizations. At least two methods that have been used to resolve this problem. _ The security can be written in terms of an independently determined loss ratio. This takes determination of the securitys coverage out of the hands of the insurer, solving the problem, but introducing basis- risk the contract covers industry losses, not the insurers own risks. _ An independent firm is hired to provide claims services.
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The Economic Basis of Insurance Risk Securitization

The basic argument in favor of insurance risk securitizations is the same argument in favor of all derivatives, namely, derivatives greatly reduce the cost of certain financial transactions. Furthermore, insurance risk securitization can: _ Increase insurance capacity; _ Allow insurers more efficient access to capital markets; _ Permit customized contracting for the hedging of risks. As one example, suppose an insurance firm wishes to reduce its exposure to some price or index and increase exposure to some other price or index. One way to do this is to sell the existing long position and use the proceeds to purchase the appropriate instruments, producing the desired exposure profile. This can result in significant transaction costs, tax effects, and market impact. Using derivatives, such a transaction can be accomplished quickly and at a fraction of the cost and the insurer can focus more directly on the risks it wants. To the extent that insurance risk securities continue to be attractive to investors, the potential for providing needed capacity for otherwise uncovered insurance exposures will continue to be exploited. In the same vein, development of more efficient risk transfer techniques will result in lower insurance prices, the elimination of some capacity-related pricing cycles, and cheaper substitutes to traditional reinsurance.
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INDIAN SECURITISATION MARKET : A SCENARIO ANALYSIS
Securitisation as a financial instrument has been in the practiced in India since the early 1990s essentially as a device of bilateral acquisitions of portfolios of finance companies. As would be the case elsewhere too, securitisation finds its way of loan sales. There were quasi-securitisations for quite a while where creation of any form of security was rare and the portfolios simply ended from balance sheet of one originator over to that of another.
Form of security
In the later part of 1990s, creation of transferable securities in the form of pass-through certificates (PTCs) became common. The word PTC has almost become synonymous with securitisation in India and most market practitioners do not envisage issuance of notes or bonds as a securitised product. A typical Indian PTC does not abide by any specific structural features there are PTCs which have a specific coupon rate, there are structured PTCs and PTCs have different payback periods. In other words, many such PTCs are essentially debt instruments it is only that they are not called as such. The issuance of PTC has so intensely been associated with the market that even for completely bilateral deals which are really speaking loan sales, people have used trusts and PTCs.
Asset classes
Over time, the market has spread into several asset classes while auto loans and residential housing loans are still the mainstay, there are corporate loans, commercial mortgage receivables, future flow, project receivables, toll revenues, etc that have been securitised. CMBS transactions that are characteristic of the Western world where the commercial real estate itself is the real collateral, are not still not
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Insurance Risk V/S Altenaytive Risk Transfer common. CLO/CDO transactions have also not surfaced as yet one solitary attempt by ICICI to float a CDO did not succeed, though single corporate loans have been securitised. Revolving structures are still not there. ABCP conduits also do not exist. Transactions are both rated and unrated. Transactions are both listed and unlisted.
Motive for securitisation

Synthetic transactions have also not emerged as yet. In fact, even for most cash transactions, capital relief does not sound like a very significant motive since the volumes are too small to have any tangible impact on the regulatory capital of the securitisers. The larger part of the countrys banking sector is still an investor rather than originator for securitisations. Thus the primary motive for most securitisers would be the skimming of excess spreads; for some, liquidity needs are obvious.
Nature and form of credit enhancements

Subordination is a commonly used form of credit enhancement. Since asset backed securities are still new, investors have a preference for AAA or AA rated instruments. Most transactions in the market, therefore, end up with a couple of senior classes. Multi-class issuances with several rated tranches are uncommon. Apart from subordination, over-collaterlisation, guarantees, recourse, cash reserves are used as other forms of enhancement. The extent of enhancements is relatively very high and not very painful, as there are no capital consequences of providing such enhancement see below.
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Legal structure
In 2002, India enacted a law that reads Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI). Though masquerading as a securitisation-related law, this law does very little for securitisation transactions and has been viewed as a law relating to enforcement of security interests, as a very narrow avatar of personal property security laws of North America. In commercial practice, the SARFAESI has been very irrelevant for real life securitisations. Most securitisations in India adopt a trust structure with the underlying assets being transferred by way of a sale to a trustee, who holds it in trust for the investors. A trust is not a legal entity is law but a trustee is entitled to hold property which is distinct from the property of the trustee or other trust properties held by him. Thus, there is an isolation, both from the property of the seller, as also from the property of the trustee. The trust law has its foundations in UK trust law and is practically the same. Therefore, the trust is the special purpose vehicle. Most transactions to date use discrete SPVs master trusts are still not seen. The trustee typically issues PTCs. A PTC is a certificate of proportional beneficial interest. Beneficial property and legal property is distinct in law the issuance of the PTCs does not imply transfer of property by the SPV but certification of beneficial interest.
Regulatory compliances
The Reserve Bank of India has a set of guidelines for banks relating to their transactions under the SARFAESI law but that contains only an opaque reference to capital relief. There are no clear guidelines on capital relief. However, it is generally felt that if a transaction attains off balance sheet treatment, it will result into capital relief.
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Insurance Risk V/S Altenaytive Risk Transfer There are no specific capital implications on account of retention of subordinated tranches, though in practice, there are substantial junior stakes or overcollateralisations present in every transaction (see under Credit enhancements above). Among the regulatory costs, stamp duty is a major hurdle. The instrument of transfer of financial assets is, by law, a conveyance, which is a stampable instrument. Many states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty on the two. The rates would therefore be weird going up to 10% of the value of the receivables. Some 5 states have announced concessional rates of stamp duty on actionable claims, limiting the burden to 0.1%, but there is an unclarity as to whether this concession can be availed for assets situated in multiple locations. The stamp duty unclarity and illogicality has in a way shaped the market players have limited transactions to such receivables as may be transferred without unbearable stamp duty costs. The SARFAESI law intended to resolve the stamp duty problem, but owing to its flawed language, did not succeed.
Taxation
The tax laws have no specific provision dealing with securitisation. Hence, the market practice is entirely based on generic tax principles, and since these were never crafted for securitisations, experts opinions differ. The generic tax rule is that a trustee is liable to tax in a representative capacity on behalf of the beneficiaries therefore, there is a prima facie taxation of the SPV as a representative of all end investors. However, the representative tax is not applicable in case of non-discretionary trusts where the share of the beneficiaries is ascertainable. The share of the beneficiaries is ascertainable in all securitisations through the amount of PTCs held by the investors. Though the PTCs might be multiclass, and a large part might be residual income certificates in effect, the market believes, though with no reliable precedent, that there will be no tax at the SPV level and the investors will be taxed on their share of income.
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Insurance Risk V/S Altenaytive Risk Transfer The scenario is, however, far from clear and the current thinking may be short lived.
Accounting rules
The Institute of Chartered Accountants of India has come out with a guidance note on accounting for securitisation. Guidance notes are issued by the Research Committee of the Institute and are recommendatory rather than mandatory. But where a method is recommended, it is expected to be followed, unless there are reasons not to. The guidance note is a mix of FAS 140 and FRS 5 approach. Generally, off balance sheet treatment is allowed, if risks and rewards are transferred. Gain on sales is computed based on the components approach underlying the US accounting standard. Originators are required to estimate the fair value of retained interests, and retained liabilities and apportion the carrying value of the asset in proportion of such retained and transferred interests. The guidance note also makes a reference to accounting for SPVs without caring for whether the issuance of securities by the SPV leads to a transfer of beneficial interest. Literally interpreted, assets transferred to SPVs should stay on the balance sheet of the SPV in all cases.
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The Obstacles & Policy recommendations

Lack of appropriate legislation
As we discussed earlier, there are no laws specially governing Securitization transactions in India. The Government of India constituted a Working Group on Asset Securitization in July 2000. This Working Group submitted a comprehensive draft Securitization Bill to the Government. However, the bill has not been tabled in the parliament yet. A comprehensive securitization Act can give a much-needed thrust to securitization activity in India. The following are the key areas where legislation is required: a) True Sale (Isolation from bankruptcy of the Originator) The central idea of a securitization transaction is to isolate the assets of the Originator from Originators balance sheet and seek a higher credit rating than the Originators own rating. A key requirement for that is to achieve a true sale of the assets to the Special Purpose Entity. b) Tax neutral bankruptcy remote SPE The special purpose entity that buys assets from the Originator should be a bankruptcy remote conduit for distributing the income from the assets to the investors. While banks have experimented with company revocable trust and mutual fund structures, no clear vehicle has emerged for performing securitization. This should be addressed by the Securitization act. c) Stamp Duties Stamp Duty is a state subject in India. Stamp Duties on transfer of assets in securitization can often make a transaction unviable. While five Indian states have recognized the special nature of securitization transactions and have reduced the stamp duties for them, other states still operate at stamp duties as high as 10% for transfer of secured receivables. The Working Group of RBI has recommended a uniform rate of 0.1% duty on all transactions. The acceptance of these
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Insurance Risk V/S Altenaytive Risk Transfer recommendations by other states can boost the securitization activity in India especially in the MBS area. d) Taxation & Accounting At present there are no special laws governing recognition of income of various entities in a securitization transaction. Certain trust SPE structures actually can result in double taxation and make a transaction unviable. The Securitization Act, when it comes to force, should address all taxation matters relating to securitization. Securitization legislation should also specify requirements for off balance sheet treatment for securitization and regulatory capital requirements for Originator and Investors. e) Eligibility Only recently Mutual funds have been allowed to invest in PTCs. The government should lay down norms governing investment eligibility for various Securitization instruments.
Debt market
Lack of a sophisticated debt market is always a drawback for securitization for lack of benchmark yield curve for pricing. The appetite for long ended exposures (above 10 years) is very low in the Indian debt market requiring the Originator to subscribe to the bulk of the long ended portion of the financial flows. The development of the Indian debt market would naturally increase the securitization activity in India.
Lack of Investor Appetite

Investor awareness and understanding of securitization is very low. RBI, key drivers of securitization in India like ICICI and Citibank and rating agencies like CRISIL and ICRA should actively educate corporate investors about securitization. Mandatory rating of all structured obligations would also give investors much needed assurance about transactions. Once the private placement market for securitized paper gathers momentum, public retail securitization issuances would become a possibility. 47
Catastrophe risk bonds

Catastrophe risk bonds provide a mechanism for direct transfer of catastrophe risk to capital markets, in contrast to transfer through a traditional reinsurance company. The bondholder's cash flows (coupon or principal) from these bonds are linked to particular catastrophic events such as earthquakes, hurricanes, or floods. Although several deals involving catastrophe risk bonds have been announced recently the concept has been around a while. Goshay and Sandor [8] proposed trading reinsurance futures in 1973. In 1984, Svensk Exportkredit launched a private placement of earthquake bonds that are immediately redeemable if a major earthquake hits Japan [14]. Insurers in Japan bought the bonds agreeing to accept lower than normal coupons in exchange for the right to put the bonds back to the issuer at face value if an earthquake hits Japan. This is the earliest catastrophe risk bond deal we know about. Some catastrophe bonds have multiple classes of risk (or tranches). Splitting bonds into different tranches can make the bonds appealing to diverse investors. One tranche may offer a higher yield in exchange for the risk that investors will have to forgive repayment of principal in the wake of catastrophe losses, appealing to investors who will accept greater risk in exchange for a higher return. Another tranche may be principal protected, appealing to investors willing to accept a lower return in exchange for lower risk. Principal-protected tranches may also qualify for higher ratings from credit rating companies, expanding the market for such tranches to institutional investors limited to investing in only higher rated forms of debt. From an investors perspective, three risks of catastrophe bonds and some other forms of securitization are that protection against catastrophe losses may lead an insurer to: relax its underwriting standards; manage the geographic concentration of its exposures less carefully;
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Insurance Risk V/S Altenaytive Risk Transfer settle claims more liberally. Some catastrophe bonds have features that mitigate these risks in much the same way as reinsurers manage the corresponding risks in standard reinsurance agreements. First, some catastrophe bonds have high triggers, which act like high attachment points in excess-of-loss reinsurance contracts. High triggers provide an incentive for insurers to maintain underwriting discipline and practice prudent risk management. Second, some catastrophe bonds require that insurers share in losses above the trigger, much as proportional reinsurance requires insurers to share in losses. Proportional sharing of excess losses provides an incentive for insurers to underwrite carefully, manage their exposure to catastrophe risk prudently and not settle claims too liberally. A special purpose reinsurer is a business entity formed specifically to issue catastrophe bonds and to then sell traditional reinsurance to a particular insurer. The use of a special purpose reinsurer eliminates the need for the insurer to carry debt on its balance sheet and also enables the insurer to deduct a reinsurance premium when calculating its net-premium-to-surplus ratio. And, if the special purpose reinsurer is offshore, it may be exempt from U.S. taxes, ultimately reducing the reinsurance premiums it must charge. A special purpose reinsurer can also protect investors from other credit risk inherent in the operations of the insurer using the special purpose reinsurer. If the insurer were to become insolvent for reasons having nothing to do with catastrophe losses, the special purpose reinsurer would still have an obligation to repay the catastrophe bonds it sold to investors. On the other hand, if a special purpose reinsurer encounters financial difficulty, the insurer using the special purpose reinsurer would not have to make its resources available.
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Catastrophe bonds catches fire

Bird flu continues rapidly to infect the worlds media, if not yet its population, spawning feverish headlines about the human and monetary costs of a potential pandemic and somewhat more absurd stories of how happiness or Sauerkraut could guard against the illness. But signs of the seriousness of the threat are evident in capital markets, where there is growing interest in the potential for reinsurers to pass on to investors in the form of so-called catastrophe bonds the costs associated with a sudden rise in deaths. Swiss Re sold $762m of catastrophe bonds in two issues in April this year and at the end of 2003, to cover extreme mortality risk in its reinsurance of life companies, of which an influenza pandemic is a significant part. We have seen significantly increased interest in transferring mortality risk, which is partly influenced by all the discussion in the media surrounding a potential influenza pandemic, says Shiv Kumar, of the financial institutions structured finance group at Goldman Sachs. More and more life companies have been transferring mortality risk to reinsurers, so there is now a concentration of that risk. Catastrophe bonds have so far mainly covered severe windstorm or earthquake risks mostly in the US. Bondholders lose money only if reinsurers suffer extremely high losses on the risks specified in the bond. Investors in one such bond a private placement named Kamp Re have incurred losses due to Katrina, the hurricane that led to the flooding of New Orleans. However, most investors in the $6bn market remain untroubled, in spite of two years of heavy US storm-related losses for reinsurers, and there is scope for further market growth.
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Insurance Risk V/S Altenaytive Risk Transfer A confluence of factors, including investor demand, rising reinsurance premiums and the needs of reinsurers to secure capacity to exploit higher premium rates could be about to spark a quickening of issuance, according to specialists at Swiss Re Capital Markets and Goldman Sachs , the two main underwriters of such deals. We recently closed a [$300m] transaction, the first since Katrina, which demonstrated that investors continue to be interested in the sector, says Michael Millette, head of financial institutions structured finance at Goldman Sachs. A pipeline is building up that is substantial. We see an expansion in the market that could lead to the same kind of step up in issuance that we saw after 9/11, which could mean issuance of $3bn or more per year. Judith Klugman, managing director at Swiss Re Capital Markets, says that even before Katrina $1.5bn of bonds had been issued in 2005. There is a robust pipeline, I think this could be one of the highest ever years for issuance, beating the $2bn in 2003, she says. This is tiny compared with insurance industry losses from the 2004 hurricane season in the US of about $20bn and losses from Katrina alone of more than $30bn, according to Fitch, the ratings agency. But Ms Klugman adds that it will take time before the effects on catastrophe bond issuance of the recent hurricane losses can be seen. However, she says investors are becoming interested in taking on riskier bets. This could mean a bigger appetite for indemnity-type catastrophe bonds, which cover cumulative losses for a reinsurer and so must pay a higher coupon, as opposed to parametric-type bonds, which are triggered by specific events, such as very high winds in Florida. But Mr Millette adds: Post Katrina, because of some uncertainties about the counting up of losses, indemnity-type bonds will now attract more investor scrutiny than parametrics, which allow claims to be settled much more rapidly.
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Insurance Risk V/S Altenaytive Risk Transfer Some parametric bonds are linked to industry-loss indices and these are among the most likely to be facing losses now. While only three public catastrophe bonds have ever experienced losses, one person in the industry says more private deals have done so and a number of reinsurers will be collecting on industry-loss parametrics, often from hedge funds. There are other options available to securitise risk, which some in the industry predict will see stronger growth than catastrophe bonds. Hannover Re last week announced a 500m securitisation plan to help revive its fortunes after being the latest in the industry to report huge hurricane losses. The group is to draw up a more traditional reinsurance contract but will place it in a special purpose vehicle funded by cash from investors such as hedge funds. Such a deal mimics the trend for hedge funds and private equity to finance individual Bermudan reinsurers, attracted by the higher premiums that follow years of heavy losses. Rodrigo Araya, analyst at Moodys, is cooler on catastrophe bond growth. There has been some pressure for issuance from the capital markets, but it takes time and is expensive, he says. But there could be a new trend in selling extreme mortality risk, because of worries about an influenza epidemic.
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Pros & Cons of Cat Bonds

The advantages of catastrophe bonds include the following:
An insurer can tailor the triggers and other provisions of catastrophe bonds to meet itsspecific needs, much like individual reinsurance contracts. When catastrophes trigger the provisions in catastrophe bonds that require investorsto forgive repayment of principal, the insurer can immediately write down its liabilityfor the bonds. Writing down the liability increases the insurers surplus, or net worth. Catastrophe bonds offer investors higher yields than otherwise comparable bonds thatdo not contain provisions forgiving principal or interest in the event of catastrophiclosses. According to the Hogue Insurance Stock Report, catastrophe bonds have beenpriced to yield three to four percentage points more than comparably rated(comparably risky) corporate bonds. Catastrophe bonds provide investors with an opportunity to reduce portfolio risk through diversification. The returns on most stocks and bonds depend to some extension economic conditions. Therefore, those returns tend to rise and fall together, making it difficult for investors to fully hedge portfolio risk by diversifying their investments. The return on a catastrophe bond depends on the occurrence of a catastrophic event fulfilling the terms of the trigger. The occurrence of a qualifying catastrophic event will result in the issuer defaulting on the interest and/or principle. Since the occurrence of catastrophes is independent of economic conditions, the default risk on catastrophe bonds is not correlated with the default risk on other bonds and stocks. Adding catastrophe bonds to a portfolio of traditional investments can improve overall investment results.
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The disadvantages of catastrophe bonds include the following:

Insurers issuing catastrophe bonds may face high transaction costs because of the need to provide significant amounts of information to investors. Investors (like reinsures) may require substantial amounts of information about an insurers exposure to catastrophe losses to evaluate the level of risk they are assuming. Their expected rate of return for assuming that risk, especially when the trigger in a catastrophe bond is based on an individual insurers loss experience. Investors need for information about the catastrophe exposure of a specific insurer may also make catastrophe bonds less liquid than similar investments without the special features of catastrophe bonds. When an insurer issues catastrophe bonds, the insurer takes on debt. That debt may make the insurer appear less financially sound than it would if it instead bought traditional reinsurance. Catastrophe bonds do not have the same beneficial effect on an insurers reported financial leverage as traditional reinsurance. For example, when calculating the ratio of net written premiums to surplus -- one widely used measure of the amount of risk supported by each dollar of surplus -- an insurer can deduct traditional reinsurance premiums from direct premiums written. Deducting reinsurance premiums reduces the premium-to-surplus ratio, making the insurer appear more financially sound. But, when using catastrophe bonds, an insurer does not pay reinsurance premiums and, consequently, cannot deduct those premiums from its direct written premiums. Therefore, the insurers premium-to-surplus ratio will be higher than it would be if the insurer instead used traditional reinsurance.
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Securitization to be high growth business, says S&P

International rating agency Standard & Poor's Richard Gugliada said transfer of risk by the device of securitisation will continue to be the mainstay of securitisation business in time to come. Thus, Cats and other credit-risk transfer devices will continue to be a very high-growth business. Richard Gugliada is the managing director of Standard & Poor's CBOs/CLOs, Market Value, and Derivatives/Structured Investment Vehicles division. Richard made these comments while addressing Strategic Research Institute's Forum on Risk Securitization in New York on 11th Sept. There have been several risk transfer based securitisation transactions recently, for example, J.P. Morgan & Co. Inc.'s Broad Index Structured Trust Offering (BISTRO) series of transactions. Other notable transactions have been Morgan Stanley's Sequils transaction, Citibank's strategic asset redeployment program, etc. Risk securitization is similar in theory to credit derivatives: the assets remain on companies' balance sheets and the issuers do not aim at the typical accounting benefits of traditional securitizations. Highly rated financial institutions can use this financing method to efficiently and cost-effectively manage credit risk to specific assets. The seller transfers its risk on a reference pool of assets by creating marketable securities and selling them in the capital markets.
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DERIVATIVES
Having covered the main areas of risk that insurance companies are likely to encounter, this paper will now examine the use of derivative securities by insurance companies. First, a description of derivative securities is provided. This is followed by an overview of the potential applications of derivatives. While much of the literature argues the primary theoretical advantage of derivatives is as a risk management tool, one must be mindful that derivatives can be used for other purposes. These are outlined later in this section. Finally, the actual usage of derivatives by insurance companies is then reviewed and explanations are offered to explain the usage or non-usage by insurance companies. 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.
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Insurance Risk V/S Altenaytive Risk Transfer Swaps are private contracts between two participants who 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 prespecified 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 contract. Derivatives trading in commodities is not a new phenomena. The trading of real options, when forward option contracts were written for the first use of olive presses, goes back to the time of Aristotle. In the Middle Ages, forward and option contracts were routinely used to hedge a ships cargo, which was a form of option taking for merchants to fund ventures by borrowing to pay for the ship and cargo. In the event there is loss of cargo and/or the ship, the debt would be written off or forgiven. Commodity forward and futures contracts have been widely used in Europe, the USA, and Australia over the past 100 years. Financial derivatives have a more recent history with much of the trading in foreign currency, interest rates, stock indices, and catastrophe insurance introduced over the last 15 years.
The Twenty-First Century

While derivatives have traditionally been associated with hedging just price risks, appropriately structured derivatives can be used to meet the demands of a broad
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Insurance Risk V/S Altenaytive Risk Transfer array of risk management challenges. Derivatives are an effective tool for managing supply risk as well as price risk. And the forward price curve created by a derivatives market allows more accurate planning and better demand forecasting. Derivative instruments traded in the appropriate regulatory environment also permit multilateral offset. For example, a company can reverse a derivatives contract it has bought by selling the contract to a third party without having to consult or negotiate with the original party. This permits companies to dynamically adjust their risk portfolio, as opposed to being locked into an inflexible multiyear arrangement with a specific counterparty. Finally, derivatives allow a company to smooth revenues on the bottom line, which has a significant effect on investor valuation and is also important in any setting with a progressive tax structure. Technology, regulations and business practices are changing to enable a new suite of risk management tools that are unprecedented in their customization and integration. The companies that take advantage of these opportunities will be rewarded with less volatile revenues and the ability to surgically target and manage new categories of risk. The ultimate goal is for corporations to be able to track their aggregate risks (in some cases, in real time) and precisely layoff those risks they wish to shed.
Regulatory Risks and Opportunities

It is inevitable that the regulatory landscape will have a profound effect on risk management. The Financial Services Reform Act of 1999, for example, is changing the way business is done in the insurance and banking industries. Of particular relevance for the use of derivatives are the new financial accounting standards (FAS 133) and the Commodity Futures Modernization Act of 2000. (A similar international accounting standard is also being adopted: IAS 39.) FAS 133 requires derivatives to be carefully tailored in order to qualify for hedge accounting treatment. Risk management hedges must stay within 80 percent to 125 percent of the value of the underlying asset or liability in order to qualify for the
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Insurance Risk V/S Altenaytive Risk Transfer more beneficial treatment. This means that one-size-fits-all hedges will no longer be appropriate. The Commodity Futures Modernization Act creates whole new categories of risk management instruments, as well as significantly modifying existing rules and regulations. Swaps now benefit from the regulatory certainty that they are not subject to regulation by the Commodities Futures Trading Commission (the federal regulatory agency for such activities) when conducted by eligible participants. Futures and options can now be traded outside a traditional futures exchange in some cases. Companies will require both customized instruments and a risk management platform that can accommodate a much wider variety of instruments than has previously been available. Responding to that need, what were once the futures pits are now online marketplacesreal-time exchanges for these risk management financial instruments.
Hedge your price risk

A cautious use of derivatives reduces price risk A farmer sows seeds, and expects a certain quantity of wheat after three months. However, he is not sure, how much he would get for his produce after three months because he does not know what the price would be at that time. He fears that if the price of wheat declines in future then his profits would also dip. On the other hand, a baker fears that if the price of wheat increases in future, his production cost will increase. Thus, there is a price risk. A farmer can hedge in forward/futures market to eliminate this price risk, and can ensure the minimum price for his produce. The classic hedging application for the wheat farmer would be forwardselling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may also want to buy wheat forward in order to assist production planning and avoid the risk of price fluctuations. Thus, forwards provide a useful tool for both the farmer and the bread factory to hedge their risks. Futures market provides an effective and efficient mechanism to manage price risk, by buying or selling futures contracts. These contracts establish a price level for
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Insurance Risk V/S Altenaytive Risk Transfer items to be delivered at a future date. Hedgers are individuals and firms who wish to buy/sell in futures decide the price in advance for products they want to buy or sell in the cash market. On the other hand, speculators look for the risks that hedgers wish to avoid. They do not have any intention of making or taking delivery of the commodity. Instead, they seek to profit from a change in the price. They buy when they believe prices will rise; and they sell when they believe prices will decline.
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Futures
The CBOT introduced insurance futures in December 1992. The initial offerings are limited to catastrophic property-insurance losses. The two instruments initially introduced cover national and eastern property catastrophes. The latter are viewed as important because of the exposure to hurricane losses on the Eastern seaboard. In May 1993, Midwestern catastrophe futures were introduced, again motivated in part by region-specific windstorm exposure. Property catastrophes are an important source of underwriting risk, as illustrated by Hurricane Andrew, which led to substantial losses of equity capital in the industry and several insurace company insolvencies. In addition to the importance of property catastrophes as a risk exposure, another reason for the CBOTs focus on property losses is that such losses settle relatively quickly and thus are not subject to the lengthy payout period and accompanying loss estimation errors that characterize other risky coverages such as commercial liability insurance and workers compensation. Property losses are relatively insulated from errors due to misstatements and manipulations of loss reserves. Due to the relatively high loss volatilities characterizing property coverages, insurers should have a strong interest in hedging underwriting risk arising from property coverages. Nevertheless, trading in insurance futures has been light. This is most likely attributable to the fact that most insurers lack experience with financial hedging. The opposite side of the market (sellers of futures) consists primarily of speculators. In addition to catastrophe futures, the CBOT is also developing homeowners insurance futures that would not be limited to catastrophic losses but would cover homeowners property losses from all sources. Our methodology could also be used to price these contracts. The insurance futures contracts introduced in December 1992 by the Chicago Board of Trade (CBOT) have a potentially important role to play in stabilizing
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Insurance Risk V/S Altenaytive Risk Transfer insurance markets by providing an alternative hedging mechanism for underwriting risk. Although the present contracts are limited to property catastrophes, futures covering other types of losses are likely to be introduced if the catastrophe futures succeed. Unlike reinsurance, hedging through futures has the advantage of reversibility since any position may be closed before the maturity of the futures contract if the overall exposure of the insurer has diminished. Although reinsurance is, in principle, also reversible, in practice reversing a reinsurance transaction exposes the insurer to relatively high transactions costs as well as additional charges to protect the reinsurer against adverse selection. Because futures contracts are anonymous rather than negotiated between two specific parties, the potential for adverse selection and the accompanying administrative costs are greatly diminished. An insurance futures market should offer the advantages of liquidity and low transactions costs that are common to futures contracts.
Methodology of hedging through futures

Consider the following case of a corn producer A corn producer uses the futures market to lock in a price for produce. The farmer here is a hedger, he is not concerned about how the cash price and the futures price moves, because both the futures price and the cash price tend to move together assuring a gain in one market to cover the loss in the other market. Futures contract for corn is traded for December, March, May, July and September delivery at Chicago Board of Trade. The contracts are for 5000 bushels of number 2 yellow corn. To begin with, the producer must decide when and how much to purchase in the future market. Trading futures requires depositing initial margin and meeting margin calls if the market moves against the futures position taken by the hedger. In the case of options, the buyer need not put up margin money, but he will have to pay an option premium. The minimum loss in this case is the option premium paid.
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Insurance Risk V/S Altenaytive Risk Transfer Suppose on June 30th the corn producer predicts that his produce will be 500,000 bushels after three months. He wants to eliminate the price risk, i.e. he wants to lock in the future price of his produce. Now, the October futures contracts are trading at $3.22/bushel, and each contract consists of 5000 bushels. This price is acceptable to the producer, so he sells 100 corn futures contracts at this price. Now on the day of maturity of the contract, if the price goes below $3.22, he is safe. On the other hand if the spot price of the corn goes above $3.22, the producer loses the additional profit. Thus, we see that futures eliminate downside risk, but limits upside profit potential.
Catastrophe Futures
A unique characteristic of insurance futures is that there exists no market price, published index value, or yield rate on which to base settlement values. Accordingly, the CBOT has had to create an underlying instrument to form the basis for futures trading. For catastrophe futures, the instrument consists of losses reported each quarter to the Insurance Services Office (ISO), a wellknown statistical agent. Approximately 100 companies report property loss data to the ISO. The settlement values for insurance futures are based on losses incurred by a pool of at least ten of these companies selected by the ISO on the basis of size, diversity of business, and quality of reported data. The list of reporting companies included in the pool for any given futures contract is announced by the CBOT prior to the beginning of the trading period for that contract. The CBOT also announces the premium volume for companies participating in the pool prior to the start of the trading period for each catastrophe contract. Thus, the premiums in the pool are a known constant throughout the trading period, and price changes are attributable solely to changes in the markets expectations of loss liabilities. Catastrophe insurance futures trade on a quarterly cycle, with contract months March, June, September, and December. A contract for any given quarter is based on losses occurring in the prior calendar quarter as reported by the participating companies at the end of the contract quarter. For example, the September 1993 contract covers losses from events occurring during the second quarter of 1993 (April 64
Insurance Risk V/S Altenaytive Risk Transfer through June) as reported by the end of September. The three additional months following the close of the event quarter, are to allow for loss settlement and data processing lags that are common in insurance. Although not all losses will be reported by the end of the two-quarter reporting period, reported pool losses should represent a high proportion of eventual paid losses, particularly in view of the fact that companies are allowed to report estimated losses in addition to those already paid.3 Of course, the use of estimated rather than paid losses introduces potential errors into the contract settlement values and may create incentives for moral hazard (see below). Unlike most insurance and reinsurance arrangements, insurance futures do not focus on a particular type of policy (such as homeowners or automobile insurance) but rather on particular types of losses. Losses included in the pool consist of all property losses incurred by the reporting companies arising from the perils of windstorm, hail, earthquake, riot, and flood. Reported losses can arise from eight different lines of insurance including homeowners, commercial multiple peril, earthquake, and automobile physical damage.4 Even though the contracts are called catastrophe futures, in fact all losses (i.e., not just catastrophe losses) for the specified perils and lines of business are included in the loss pool. However, the losses in the pool are expected to be highly correlated with property catastrophe losses because the included perils were chosen as those most susceptible to catastrophes. The use of a proxy approach rather than true catastrophe losses seems to have been motivated by the need to limit data processing costs. Trading begins as soon as a contract is listed and ends on the fifth day of the fourth month following the contract month. Thus, settlement on the September 1993 futures takes place on January 5, 1994. Contract settlement is based on the loss ratio of the business reported to the ISO pool, i.e., the ratio of reported incurred losses to earned premiums.5 The contracts trade in units of $25,000 with prices quoted in percentage points and tenths of points. E.g., a price of 11.2 corresponds to a loss ratio of 11.2 percent and an expected settlement value of $25,000*. 112 = $2,800.
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Options
While forward or future is an obligation to buy or sell some asset at a future date at an agreed price, an option is a choice to buy or sell the asset at some future date at an agreed price. In a forward or futures contract, both parties offer to perform (to buy or sell) as per the terms of the contract. In an option contract, one party, namely, the option holder has the option to buy or sell the underlying asset according to the terms of the contract. The option may or may not be exercised; there is no obligation. The counterparty who writes the option (called option writer) is obligated to sell the underlying asset, if the option holder chooses to buy or buy the underlying asset if the option holder chooses to sell. There are many different types of options: options to buy an underlying asset (call option) and options to selKput option); the options may be with a single exercise time (European Options) and options that can be exercised over a time period (American Options). We may discuss here simple types of call and put options. A call option is an option to buy an underlying asset, say equity shares. Abhijit holder of a call option - has the right but no obligation to purchase, say 1000 shares of Hindustan Lever Limited (HLL) at some future date, say, on 25tn August,2003 at a fixed price, say Rs.170, called exercise price or strike price. If the price of HLL at maturity (25tn August,2003) exceeds the exercise price, say, Rs.180 on that day, Abhijit, the option holder, can exercise the option and buy 1000 HLL shares at Rs.170. Abhijit makes a profit of Rs.180-170 multiplied by 1000, that is, Rs.10,000. Assume HLL price on 25tn August is less than the strike price of Rs.170, say Rs.162. If now, Abhijit exercises the option, he would be buying a share of HLL at Rs.170; when he can buy the same in the market at Rs.162. As a rational investor, Abhijit would simply not exercise the option; he would let the option expire worthless. Let us consider the position of the option writer, say, Lakshmi. She has no choices to make at maturity of the option. If Abhijit exercises the option to buy HLL share, Lakshmi is obligated to honour that choice and sell 1000 HLL shares at the
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Insurance Risk V/S Altenaytive Risk Transfer exercise price of Rs.170. With a price rise, the option will be exercised by the option holder and the writer will have to sell the share at the strike price. In the above example, Lakshmi incurs a loss when the HLL price rises to Rs.180 and the strike pri'ce contracted was Rs.170 - Rs.10 multiplied by 1000 shares. That is, Rs.10,000. However, as Abhijit, the option holder has to purchase the call option from Lakshmi, the option writer, say, at Rs.2 per share, the amount of Rs.2000 (Rs.2 x 1000) is kept by Lakshmi whether or not the option is exercised by Abhijit. The net profit / loss to the option writer, if the option is exercised is equal to (call option price + strike price - price of the share at maturity) x No.of shares underlying the option The other main class of options is the put option. A put option is the option to buy an underlying asset. The put option holder buys the right to sell an underlying asset at some future date (maturity date) for a price agreed upon now - exercise price or strike price. The option - writer, the counter party, sells the right to the put holder to sell the asset to the option-writer. If the put option holder exercises his right to sell the underlying asset at maturity, the option writer is obligated to buy the asset at the strike price. Whether the option holder of a put would exercise the option or not depends upon the spot price of the stock at maturity. If the spot price of the asset at maturity is above strike price, the option holder will not exercise his option and the option expires worthless. On the other hand, if the spot price at maturity is below the strike price, then the put option holder will exercise the option and will sell the asset to the option writer at a price higher than what he could get for it in the market. Whether option holder or option writer gains in the transaction depends upon the strike price and price of the underlying asset at maturity. However, one thing is clear. The profit of the option holder is a loss to the option wrfter and vice versa. We may also note that writing a call is speculating on a downward price movement and writing a put is speculating on an upward price movement of the underlying asset. Further, the call holder is speculating on rise in price of the underlying asset while the put holder is speculating on a price fall. Although there are a variety of different types of options (e.g., stock options, index options), this section will focus exclusively on stock options. Once you understand the basic principles, they can easily be applied to the other financial
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Insurance Risk V/S Altenaytive Risk Transfer instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by their company in a number of important ways. First, they typically have shorter-term expirations. Options granted by companies are often good for several years. During that period, they can be exercised (converted to stock) at any point. However, employee stock options cannot usually be sold or transferred. In contrast, exchange traded options (with the exception of LEAPS) are generally valid for only a few months and can be bought or sold at any time prior to expiration. To many people, it seems odd that exchange-traded options are not issued by the companies themselves. Instead, they are issued by the Exchange Options Clearing (EOC). By centralizing and standardizing options trading, the EOC has created a more liquid market. Unless otherwise specified, each option contract controls 100 shares of stock. In simplest terms, an option holder has the right, but not the obligation, to buy or sell a particular stock at a set price (strike) on or before the day of expiration (assignment). For example, someone holding a Nifty June 1120 Call would have the right to buy 200 units of Nifty for 1120 per unit. Likewise, a Nifty June 1120 Put gives the holder the right to sell 200 units of Nifty for 1120 per unit.
Methodology of hedging through options

The corn producer can also eliminate his price risk by hedging through options. The producer can buy the put option for 100 option contracts; this will provide him the right without any obligation to sell the produce at contracted price. However, for this the producer needs to pay option premium. For instance at a price of $3.22/ bushel for a 5000 bushel contract, the option premium is $61. Therefore, the option premium for 100 contracts totals to $6100. Scenario 1
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Insurance Risk V/S Altenaytive Risk Transfer Now, if the spot price on the day of expiration is $3.27 (above the exercise price of $3.22). the producer does not exercise his option of selling corn at $3.22; instead, he sells in the spot market at $3.27. His additional profit is equal to: [($3.27 $3.22) * 5000 * 100] - $6100 = $18900 Scenario 2 If the spot price on the day of expiration of contract is $3.17(below the exercise price of $3.22). In this case producer exercises the option of selling corn to an option writer. Thus he minimises his loss by [($3.22 $3.17) * 5000 * 100] = $25000 by paying only the option
premium of $6100. Thus we see that options eliminate downside risk by paying a small amount of option premium while having unlimited profit potential.
Catastrophe Options
Insurers that want protection against catastrophe losses can buy exchangetraded catastrophe options from investors. Exchange-traded catastrophe options are standardized contracts based on catastrophe indices. The indices reflect the catastrophe experience of large sets of insurers or the entire property/casualty insurance industry. The contracts entitle the buyer of the option to a cash payment from the seller if catastrophes cause the index used in the options to rise above a strike price, or trigger, specified in the options. Such cash payments can help an insurer bolster its surplus and pay claims in the wake of catastrophe losses. Investors incentive to sell catastrophe options is the payment they receive from insurers for doing so. If catastrophe losses are too low to cause the index used in a catastrophe option to rise to the specified strike price, the option expires worthless and the investor who sold the option keeps the funds received for selling the option. Insurers and investors can trade options based on catastrophe indices compiled by ISOs Property Claim Services (PCS) unit on the Chicago Board of Trade (CBOT).
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Insurance Risk V/S Altenaytive Risk Transfer Insurers and investors can trade catastrophe options based on the Guy Carpenter Catastrophe Indices (GCCI) on the Bermuda Commodities Exchange (BCOE).
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Pros & Cons of Catastrophic options

The advantages of exchange-traded catastrophe options include:
Because exchange-traded catastrophe options are standardized contracts based on catastrophe indices, an insurer (purchaser) does not have to provide a wealth of new information to investors (sellers) each time it wants to attract additional risk capital.This lowers transaction costs compared to those incurred issuing catastrophe bonds or other customized securities. Both investors and insurers have ready access to the specifications for exchange traded catastrophe options and the historical performance of the catastrophe indices used in settling those contracts. Thus, investors do not face the risk that individual insurers knowledge of their own exposure to catastrophe losses or the individual insurers loss experience will place investors at a disadvantage when trading catastrophe options (low counterparty risk). The use of organized exchanges and standardized, index-based contracts makes it easier for investors and insurers to liquidate positions in catastrophe options than positions in catastrophe bonds or other insurance-linked securities. To liquidate a position in catastrophe options, an investor need only buy options with the same strike price as the options he sold. This offsets the financial effects of the having sold options. Similarly, an insurer need only sell options with the same strike price as the options he purchased. As a rule, option exchanges use clearinghouses to settle trades. The clearinghouses guaranty that investors selling exchange-traded options will be paid. And, the clearinghouses collect margin deposits from investors selling options, enabling the clearinghouses to guaranty that insurers will receive payment when their catastrophe options finish in
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Insurance Risk V/S Altenaytive Risk Transfer the money. That is actual catastrophe losses cause the catastrophe index used in settling the option to rise above the strike price for the option, resulting in a payment to the insurer that bought the option. Because investors returns on catastrophe options depend on catastrophe losses, and less on economic conditions, returns on catastrophe options are not closely correlated with the returns on other investments. Thus, investors can use catastrophe options to improve the performance of investment portfolios, much like the way investors can use catastrophe bonds.
The disadvantages of exchange traded catastrophe options include:

An individual insurers loss experience may not closely match the loss experience underlying the catastrophe index used in a particular option. Thus, an insurer may suffer high catastrophe losses but find that its catastrophe options expire worthless because the index did not reach the strike prices for the options. At other times, an insurer may suffer only minor catastrophe losses but nonetheless collect on its catastrophe options. The possibility of a poor correlation between an insurers loss experience and the performance of catastrophe options -- called basis risk can reduce options effectiveness as a substitute for reinsurance. The amount of basis risk varies by insurer, depending on how its mix and distribution of exposures compares to that underlying the catastrophe index used in settling specific catastrophe options. Basis risk would probably be reduced by the purchase of varying numbers of catastrophe options by region or state. To minimize basis risk, it is necessary that the insurers geographic distribution match the geographic distribution underlying the index as closely as possible in catastropheprone areas. Construction other building factors are not as important. For example, a commercial property insurer should be able to construct an effective hedge using a personal
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Weather Derivatives - Hot ! Hot ! Hot !

Weather Derivatives ensure continuous cash flow in spite of adverse weather conditions. The Chicago Mercantile Exchange (CME) Heating Degree Days (HDD) and Cooling Degree Days (CDD) options and futures are the first exchange-traded weather derivatives. So far, they are confined to temperature alone. Till today, there is no standard model for pricing weather derivatives. Hence, pricing weather derivatives still remains a challenge. How weather derivatives work? Example I Consider the case of ABC Power Inc., a small energy company operating in Canada. It supplies energy to industries, homes and offices. As temperature levels in northeastern Canada are very unpredictable, ABCs sales volume is very volatile, demand for energy being directly proportional to temperature. ABC charges the same per-unit cost to its customers, no matter what the demand is. The company generates power locally using its own power plants. If the demand for power increases and ABC cannot supply, then the company has to buy the power from the open market at a higher price. Thus, ABC wants to take a position in weather derivatives, which can compensate ABC from losses due to unexpected weather conditions. Hedging Methodology ABC accessed historical databases and used regression analysis to find a correlation between temperature and the demand of power. They found that at 18 C, power usage is minimum. In case the temperature goes above this level, people start using air conditioners. In case temperature level goes down, people use heaters. In both the cases, demand goes up.
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ABC wants to hedge the losses attributed to unanticipated weather changes. Technicalities of Weather Derivatives Before getting into a hedging strategy, it is necessary to understand the technicalities of weather derivatives. For a clear understanding, weather derivative based on temperature is discussed. The most common underlying variable of a weather derivative is the cumulative number of cooling or heating degree-days. A degree-day measures the deviation of days average from the base temperature (18C). An observed winter temperature below the benchmark is recorded as a heating day. If the average daily temperature of a particular day is 15C then the HDD will be 18-15 =3. It means that 3 of heating is required to reach the standard temperature. The daily HDDs are accumulated to give the total number of HDDs for a contract period. If the contract period is the winter season, the number of HDDs are calculated as: Daily HDD = Max [0, 18 - Tt] where Tt is the average daily temperature. Daily CDDt measures how high the average temperature is, relative to a benchmark temperature. If the average daily temperature of a particular day is 22C then the CDD will be 22-18=4. It means that 4 of cooling is required to reach the standard temperature. Daily CDD = Max [0, Tt - 18C]. HDD is a measure of low temperature below the standard temperature while CDD is a measure of high temperature above the standard temperature 74
Insurance Risk V/S Altenaytive Risk Transfer The CME has developed an index for weather derivatives as follows: The CME HDD is calculated by multiplying the value attached to each HDD to the accumulated HDD. For example, suppose USD 1000 is attached to each HDD. Assuming that average daily HDD for a city for the contract period, which is one month (30 days), is 20 HDDs. Then the nominal value of index is USD 1000 * 20 * 30 = USD 600,000. Example II Consider XYZ, a gas utility company located in the Northern US. In case the winters are milder than normal, the company foresees losses. From historical data, XYZ determined that the average number of HDDs for this period over the last 30years was 5,330. It further calculated that, at this level revenues would amount to USD 50mn. XYZ estimated that each drop in the level of HDD would result in revenue loss amounting to USD 12500. The management was ready to bear a revenue loss of 10%, which would occur in case weather was 7.5% warmer, but beyond that it wanted to hedge the position. Lets assume that XYZ makes an arrangement with E Corp. It provides XYZ with a floor of 4930(5330 7.5%) HDDs. For every HDD below this level, E Corp will pay the company USD 12,500. For purchasing this protection, XYZ has to pay a premium to E Corp., while it retains the additional revenues, if the weather is colder than the accepted level. (see the following figure)
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Usage This is one of the methods to hedge risk due to unanticipated weather conditions. Different strategies are used to cover different types of risks. Weather forecasting helps in determining the type of contract and the rate at which the contract can be executed.
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DERIVATIVES: DO THEY HAVE A PLACE IN ERM?

Buffett's comments notwithstanding; derivatives can be a useful tool Derivatives have long been used for the effective mitigation of price and supply risks of various commodities.... for more than 100 years, the numerous futures exchanges have been hedging risks associated with currencies, commodities, and interest rates. The hardening insurance market is requiring corporations of all sizes to consider a wide variety of risk financing options. Most corporate risk management executives have to keep an open mind regarding potential solutions, even those that would have been dismissed outright just a few years ago. These are trying times for risk managers and they can ill-afford to leave any stone unturned. Such is the case with the use of derivatives. While these financial instruments have been part of the financial landscape for more than 100 years, their potential use by corporate risk managers is still relatively new. However, the convergence of the capital markets and insurance markets, coupled with escalating property/casualty insurance premiums may open the door to further derivatives utilization. Derivatives have long been used for the effective mitigation of price and supply risks of various commodities. In fact, for more than 100 years the numerous futures exchanges have been hedging risks associated with currencies, commodities, and interest rates. And since the 1970s, derivatives have become a financial mainstay of most corporate treasury departments. Insurance derivatives The use of derivatives over the past few years has literally exploded, and one of the largest users today has become the insurance industry. Following several major natural catastrophes, the industry realized that capacity shortages could clearly 77
Insurance Risk V/S Altenaytive Risk Transfer damage the long-term viability of the industry. As a result, insurers and reinsurers turned to the near inexhaustible capacity of the global capital markets. In addition to the additional capacity that the capital markets bring, other advantages include low transaction costs as well as greater leverage from these transactions. The industry also found that derivatives have a high degree of flexibility in both form and design and make an ideal instrument for hedging. The basic concept of derivatives has remained the same over the years. In essence, derivatives are defined as financial instruments that do not constitute ownership, but rather a promise to convey ownership in the future. Simple examples of derivatives are options and futures. All derivatives are based on some underlying cash product. Risk management departments As corporate risk management has expanded over the past 10 years or so, risk managers have struggled to determine where derivates fit into enterprise-wide risk management programs. As the barriers to integrated risk management began to disappear, initially it was the insurance companies that began to fill the need for integrated products. Several major insurance carriers began to offer innovative products, which incorporated property/casualty coverages with a variety of financial risks. However, as the enterprise risk management (ERM) concept has developed, the hard market has caused most insurers to back away from the integrated model. Once again, the risk management community is looking to the capital markets for potential solutions. At this point, while derivatives have traditionally been associated with hedging just price risks, many risk management professionals believe that appropriately structured derivatives may be used in diverse ERM programs. Significant movement in this direction had occurred by the start of the new millennium. A number of progressive risk management departments had taken up the banner for derivative use and had developed sophisticated ERM programs to support their position. For a period of time, one could not attend any ERM conference without
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Insurance Risk V/S Altenaytive Risk Transfer hearing presentations by some of these proponents. Unfortunately, one of these cutting edge companies was Enron. As a result of these examples of "progressive" derivative use, most risk management professionals began to back away from their use. The problem, however, as with Barrings Bank and others before them, was not so much an issue of the derivative trading itself, but rather its uncontrolled, undisciplined use and a lack of proper monitoring. And in the case of Enron, management took this to a new level of abuse. "Financial weapons of mass destruction" Then, like a shot out of the blue came warnings from the Oracle of Omaha regarding derivative use. In a letter to Berkshire Hathaway's shareholders in early March 2003, Warren Buffett decried the use of derivatives and derivative trading. Buffett and Charlie Munger, the vice chairman of the investment and insurance company operations, characterized derivatives as "time bombs." They warned that derivatives were "financial weapons of mass destructions," and they were "potentially lethal" to the economic system. Among Buffett's concerns was "the parties to derivatives ... have enormous incentives to cheat in accounting for them." And despite the Financial Accounting Standards Board taking action in June 1998, via the issuance of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, according to Buffett, significant risks remain. While FASB No. 133 did provide a comprehensive standard for the recognition and measurement of derivatives and related hedging activities, its complexity is well known in accounting circles. The major problem occurs when accounting for these financial instruments, companies are allowed to use "market-to-market" rules that often permit them to establish their own fair market value of the contracts. And as with Enron, this could lead to using derivative contracts to hide volatile assets and to inflate the value of new businesses.
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Insurance Risk V/S Altenaytive Risk Transfer An additional concern noted by Buffet was that large amounts of market risks have become concentrated in the hands of relatively few derivatives dealers. These dealers have already been exposed in the gas and electricity business where derivative activities have significantly diminished. But, he goes on to say other derivatives businesses continue to go on unchecked. Conclusion Whether or not derivates will ultimately be the "financial weapons of mass destruction" that Warren Buffett warned of or will become a staple in many progressive companies' ERM program, only time will tell. One thing is certain, however: Successful financial strategies that incorporate derivatives have been in use since long before Enron, and the future use will likely continue despite Buffett's dire warnings. The real question is whether we stop using an instrument that has proven useful because it can be abused rather than work to eliminate the potential for abuse. Good risk management would dictate that this alternative, like any other, be fully explored prior to use to make certain this approach is consistent with a company's overall corporate and risk management objectives. Only when a company has assured itself that it fully understands the risks and rewards of using derivatives and it has developed appropriate mitigation precautions, should derivatives be incorporated into an ERM program. But given today's current business climate, proper utilization of derivative instruments may well be a key component in ERM's expanding role.
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Exchange Traded Insurance
Many insurance industry participants believe that capital markets have the potential to bear some types of insurance risks more efficiently than insurance markets. In recent years, insurers have begun issuing securities linked to bundles or insurance risk, most commonly catastrophe risk. This report explores the prospects for these capital market solutions by first examining the general nature of financial innovation and then assessing current market developments. Following Hurricane Andrew and the Northridge earthquake of the early 1990s, property catastrophe reinsurance was in short supply and premium rates more than doubled. In reaction to this rate spike, some insurers began developing a new class of financial instruments that transfer insurance risk to capital markets. Approximately USD 12.6 billion worth of these capital market insurance solutions have been issued worldwide in the past five years. Nearly two-thirds of these transactions have involved catastrophe bonds, swaps and options. Other transactions include contingent capital and life insurance securitisations. After several years of rapid growth, the pace of issuance slowed in 1999 and 2000, Capital market insurance solutions offer issuers several advantages, including the potential to reduce counterparty risk and to diversify funding sources. Investors benefit from new opportunities to diversify their portfolios and earn high risk-adjusted returns.
Advantages for issuers

1. Pricing and availability Large-scale purchasers of reinsurance often find that the coverage they seek is either unavailable or prohibitively expensive. This is because reinsurers limit their exposure to any one risk. Consequently, securitisation can sometimes cost less than traditional reinsurance or can offer capacity that is not available on the traditional reinsurance market. Moreover, securitisation provides multiyear coverage at a set
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Insurance Risk V/S Altenaytive Risk Transfer price. Multiyear pricing insulates the issuer's cost structure from fluctuations in reinsurance prices. 2. Credit risk Purchasers of reinsurance take counterparty risk into account when choosing their reinsurers. The times when reinsurance matters most are often the times when reinsurers are undergoing financial stress. Insurers therefore diversify their sources of reinsurance and prefer doing business with financially strong reinsurers. As evidence of this preference, reinsurers rated below AA as of 1999 wrote just one-fifth of reinsurance premiums Capital market insurance solutions can be structured to minimise credit risk. When catastrophe bonds are issued, the funds collected are invested in investmentgrade securities and guaranteed by a highly rated company. TJje securities are held as collateral in a trust account for the benefit of the reinsured and the investors. A nonUS reinsurer usually establishes the trust account as a special purpose vehicle (SPY), which transforms the risk frprn reinsurance risk into an investment security. Because the SPV holds capital dollar for dollar against all potential claims, the arrangement can offer greater credit quality than conventional reinsurance, albeit at greater cost.
3. Diversifying sources of capacity Companies seeking to minimise the cost of financing diversify their funding sources. Even if one source of credit is slightly more expensive than another, a company might still access both just to be prepared for changing market conditions. Similarly, even if insurance securitisation is now more costly than reinsurance, it may still pay to tap the market. Doing so will allow quick and easy market access should changing conditions make securitisation the lowest-cost source of coverage.
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Advantages to investors
1. High expected returns Catastrophe bonds typically pay interest rates close to those for similarly rated esoteric structured paper. These rates tend to be higher than those for corporate debt and traditional asset-backed paper (e.g. MBSs, credit card receivables) carrying the same credit rating. In particular, a representative sample of 17 catastrophe bonds issued from 1997 to 2000 were priced at an average spread of 4.2% above the riskfree London Interbank Offered Rate (LIBOR), even though their expected losses averaged just 0.6%. These high spreads compensate investors for: the relative illiquidity of catastrophe bonds; model risk (concern that expected losses are actually higher than estimated); and the non-traditional nature of the securities.9 2. Portfolio diversification Empirical analyses show that the occurrence of insurance-related events is uncorrelated with the returns to stocks and bonds. Thus, investing in insurance-linked securities (ILSs) reduces the overall riskiness of an investment portfolio.
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Market evolution
Deciding how to package a given risk or group of risks is not an exact science. Risks can be packaged in many different ways, only some of which will succeed. Property catastrophe risk, for example, can be packaged as a bond, swap, fotore, or option. catastrophe risk, for example, can be packaged as a bond, swap, future, or option. Even among securities with identical cash flows, investors feel more comfortable with some than with others. Because they invest chiefly in bonds, insurers might prefer thinking of cat risk as a bond rather than a swap. The choice of structure also has legal, regulatory, and tax consequences. Underwriters must experiment with a variety of structures to discover ones that appeal to investors as well as issuers. Exchange traded insurance solutions, like any other innovation, entail substantial start-up costs. In the face of great uncertainty, pioneers must invest millions of dollars in personnel, training, and legal costs while experimenting to see what types of solutions work for clients. These costs will decline over time once successful financial products become standardised, personnel gain experience and the legal obstacles are overcome. Markets evolve. Many innovations fail to attract investors. Those that succeed attract attention and imitation. New entrants innovate further, creating variations of successful instruments designed to better meet the needs of particular issuers or investors. The regulatory or investing climate can change suddenly, as regulators view an instrument with greater suspicion or investors lose interest in an asset class. New tax or securities laws can put an end to one security structure while giving rise to others. Just as climactic change in a rain forest favours certain plants and animals, changes in the financial environment spell the end of certain innovations while calling forth others. Discussions with industry participants point to following factors that are critical to the successful development of capital market insurance solutions.
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1. Hard reinsurance market By far the most important determinant of the success of exchange traded insurance solutions is whether they can offer issuers competitive pricing. Rising reinsurance rates in the early 1990s stimulated the demand for capital market insurance solutions to substitute for reinsurance. Just as these solutions began to develop in the mid-1990s, however, reinsurance premium rates declined to levels so low that capital market insurance solutions were, by and large, no longer competitively priced (Figure 5). Box 3 describes another example of how poor timing can thwart financial innovation. A hardening of the reinsurance market would help foster greater acceptance of exchange traded insurance solutions. A major catastrophe or a downturn in securities prices that renders several insurers insolvent could precipitate this. The unavailability of ample, reasonably priced insurance or reinsurance has spurred innovation before, accelerating the growth of captives in the 1970s and the founding of the Bermuda market in the 1980s. 2. Liquidity Another key attribute of insurance linked-securities (ILSs) is their liquidity. If the secondary market for these securities is active, investors can unwind their positions with a minimum or difficulty and at low cost. The absence of this liquidity makes the securities a less attractive investment vehicle. The need for liquidity is a 'chicken-and-egg' problem: for the pricing on ILSs to improve, more investors must become interested in them. Investors, however, would rather see more deal flow before devoting time and effort to analysing these securities. Traditional reinsurance markets are far less liquid than securities markets, An active market for ILSs could make insurance risks substantially more liquid than they are today. Experimentation will include the creation of new contracts on established commodity exchanges and the development of entirely new exchanges dedicated to the efficient exchange of risks among insurers. Both approaches have been tried; each
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Insurance Risk V/S Altenaytive Risk Transfer is a reasonable possibility. Just as leading securities firms have found it worthwhile to create new electronic exchanges to facilitate the efficient trading of stocks and bonds, insurers should find value in developing efficient mechanisms for sharing risks. If the market for ILSs attains a critical mass, it will command more serious attention from institutional investors. Today, mortgage-backed securities are viewed as an asset class. Many institutional investors routinely allocate a set percentage of their portfolios to these securities based on their overall return, risk, and correlation characteristics. Once ILSs develop a track record, they too can strive to achieve the status of a regular asset class. 3. Transparency A key advantage of exchange traded insurance solutions is that they permit greater transparency, thereby allowing a larger group of investors to bear a given risk than was previously feasible. This advantage is important because capital market insurance solutions compete with reinsurance, a mature, standardised means of risk transfer that is widely accepted in the marketplace and simple to execute. The reinsurance industry is global, well established, and possesses the expertise needed to underwrite a wide range of risks. For exchange traded insurance solutions to succeed, the benefits of transparency must outweigh the information advantage and skills that reinsurers possess. This suggests that the lines of business that can be securitised most efficiently are those for which the risks are transparent and understandable to potential investors from outside the industry. Developing standardised ILS structures will enhance this transparency, broadening the range of potential investors. In support of these efforts, insurers must also undertake technological investments to standardise record keeping throughout the industry in order to facilitate the exchange of risks. 4. Resolution of regulatory, accounting, and tax ambiguities Regulatory, legal, tax, and accounting rules heavily influence whether, and how widely, a financial innovation is adopted. As the rules and regulations governing exchange traded insurance solutions grow clearer, insurers will become more willing
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Insurance Risk V/S Altenaytive Risk Transfer to secu-ritise their risks. One survey found this to be a factor critical to the success of exchange traded insurance solutions (see Box 2).15 Because of their newness, however, some capital market reinsurance solutions presently receive less favourable regulatory treatment than reinsurance. As tax and regulatory authorities grow familiar with these instruments, they will be better equipped to establish clear standards and regulations. The recent trend in many countries has been to develop regulation along functional lines, in recognition of the great similarity of various financial instruments (see Box 4). It is in the interest of leading insurers to work together with supervisors to promote a better understanding of the role that exchange traded insurance solutions play and of what an appropriate regulatory framework might be. 5. Specialisation Exchange traded insurance solutions permit a more efficient allocation of capital and division of labour through specialisation. With the advent of the mortgagebacked securities market, a US bank typically makes a loan and then sells it to an agency such as Fannie Mae or Freddie Mac, which in turn bundles the mortgages, offers credit enhancement, and services the loans. A similar development may be in store for ILSs. Today, primary insurers sell policies, invest the premiums, service the policies, and manage the liabilities. In coming years, an established market for ILSs would allow different industry players to assume more focused roles. Some firms might become 'virtual insurers', marketing policies by direct mail or phone and then immediately selling off"the policies. Banks, for one, might find this role attractive. Other firms might be securitisers, purchasing policies from a variety of direct insurers, packaging them in ways that appeal to investors (perhaps offering credit enhancements), and then reselling them. Major reinsurers or firms with experience in securitising assets could be naturals for the role. Another market niche involves servicing the individual policies - collecting premiums and processing claims - for which a service fee can be collected. Firms with efficient, low-cost back-office capabilities might be especially suited to the role. Finally, firms that can effectively structure and sell ILSs to clients can earn
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Insurance Risk V/S Altenaytive Risk Transfer commissions or placement fees. Investment banks, insurance brokers, and reinsurers are candidates for this role. In short, those who specialise and excel at specific stages of the securitisa-tion process stand to profit.
Outlook
Exchange traded insurance solutions are still evolving. Once market leaders resolve key issues such as standardisation, regulation, and education, an active secondary market for insurance risk will develop. This in turn will make Exchange traded insurance solutions accessible and attractive to an expanding universe of issuers and investors. To date, the predominant example of capital market insurance solutions has been catastrophe securitisations, We foresee annual cat securitisations, whose issuance volume has exceeded USD 1 billion in recent years, growing to perhaps USD 10 billion by 2010. But this is just the beginning. There is vast market potential for Exchange traded insurance solutions linked to nqn-catastrophe risks as well. The possibilities are many. One promising area is life securitisation, which offers insurers an economical way of financing policy acquisition costs. Another promising opportunity is in lower layers of coverage. Until now, securitisations have focused on low frequency/high severity risks. This area, though important, is limited in scope. Many practitioners foresee growing securitisation activity in middle frequency/middle severity covers such as motor insurance. Securitising these risks would improve capital and tax efficiency.
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SWAPS
What is a swap?
A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first. Both payments take place on specified dates. Different formulas are used to determine what the two sets of payments will be. Classification of swaps is done on the basis of what the payments are based on. The different types of swaps are as follows. Interest rate swaps Currency Swaps Commodity swaps Equity swaps credit default swaps total rate of return swaps equity default swaps Interest rate swaps The interest rate swap is the most frequently used swap. An interest rate swap generally involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon rate usually corresponds to the yield on a Treasury Note with a comparable maturity. Although, this can also be variable.
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Insurance Risk V/S Altenaytive Risk Transfer Additionally, there will be a spread of a pre-determined amount of basis points. This is just one type of interest rate swap. Sometimes payments tied to floating rates are used for interest rate swaps. The notional principal is the exchange of interest payments based on face value. The notional principal itself is not exchanged. On the day of each payment, the party who owes more to the other makes a net payment. Only one party makes a payment. Currency swaps A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps. Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers. A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date. Commodity swaps In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow. Commodity swaps are used for hedging against Fluctuations in commodity prices or
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Insurance Risk V/S Altenaytive Risk Transfer Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries) A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices. Equity swaps Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to buy it back at market price at a future date. However, he retains a voting right on the shares. Credit default swap In a credit default swap, the protection buyer continues to pay a certain premium to the protection seller, with the option to put the credit to the protection seller should there be a credit event. Unless there is a credit event, there is no exchange of the actual asset or the cashflows arising out of the actual asset. Total rate of return swaps In a total rate of return swaps, the parties agree to exchange the actual cashflows from the asset (say a bond), including the appreciation and depreciation in its market value, periodically, with returns referenced to a certain reference rate. Say, the reference rate is LIBOR. The protection buyer will get LIBOR + x bps, and pay over to protection seller all he earns from the reference assets. Thus, he replaces the returns from the reference asset by a return calculated on a reference rate - thereby transferring both the credit risk as well as the price risk of the reference asset.
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Insurance Risk V/S Altenaytive Risk Transfer Equity default swaps Equity default swaps, relatively new in the marketplace, use a substantial and non-transient decline in the market value of equity as a trigger event - assuming that a deep decline in the market value of equity is either indicative of a default or preparatory for a default. For more on equity default swaps, see here. Credit linked notes Credit linked notes package a credit default swap into a tradable instrument - a note or a bond. The credit linked notes may be issued either by the protection buyer himself or by a special purpose vehicle. A credit derivative may be reference to a single reference entity, or a portfolio of reference entities - accordingly it is called single name credit derivative, or portfolio credit derivative. In a portfolio derivative, the protection seller is exposed to the risk of one or more constituents in the portfolio, to the extent of the notional value of the transaction. Basket default swap A variant of a portfolio trade is a basket default swap. In a basket default swap, there would be a bunch of names, usually equally weighted (say with a notional value of USD 10 million each). The swap might be, say, for first to default in the basket. The protection seller sells protection on the whole basket, but once there is one default in the basket, the transaction is settled and closed. If the names in the basket are uncorrelated, this allows the protection seller to leverage himself - his losses are limited to only one default but he actually takes exposure on all the names in the basket. And for the protection buyer, assuming the probability of the second default in a basket is quite low, he actually buys protection for the entire basket but paying a price which is much lower than the sum of individual prices in the basket. Likewise, there might be a second-to-default or n-th to default basket swaps. Components of swap price
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Insurance Risk V/S Altenaytive Risk Transfer What are the components of a swap price? There are four major components of a swap price. Benchmark price Liquidity (availability of counter parties to offset the swap). Transaction cost Credit risk Benchmark price Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counterparties for long duration swaps, especially so in India. Transaction Costs Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) 10% The transaction cost in this case would involve 0.5% Credit Risk 94
Insurance Risk V/S Altenaytive Risk Transfer Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.
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Lets sum up
Risk is there in every walk of life. It is a thing that cannot be avoided. Previously we use to transfer the risk through traditional insurance techniques, but with the financial reforms there came a phenomenal change both in the minds of the people & also in the ways of transferring risk . ART has been a buzzword for many years now. As a market, it has seen a long list of players come and go. Those who remain have demonstrated that they possess the expertise and long term stability that corporates require to design and implement effective risk financing strategies strategies that not only supplement, but integrate with, conventional insurance capacity and traditional capital market tools. Experience, financial strength, creativity, and partnership are the key elements in executing a successful ART programme. When these elements are given the necessary time to gel together, the result is a dynamic solution capable of addressing the most intractable problems. The economic justification for insurance risk securitization is that insurance risks are repackaged and sold to the capital market so investors can distribute their capital over these risks more efficiently than they could when the risks were contained in the original risky securities. This holds regardless of individual investor risk preferences or wealth. As long as this increase in efficiency is possible, insurance risk securities should continue to proliferate in the capital markets. The effects of more efficient risk transfer and risk sharing will manifest themselves in the form of more insurance coverage of assets, better insurance pricing, and lower capital costs for insurers and reinsurers. The use of derivatives for the purpose of managing financial risks, such as interest rate risk, commodity price risk and foreign exchange risk is gaining prominence during the last two - and - one half decades. It is increasingly realized that 97
Insurance Risk V/S Altenaytive Risk Transfer even for insurable risk (apart from financial risk) derivatives can be profitably used. Insurance contracts themselves are seen to be like derivatives.The structure of insurance contracts possesses an "option-like* structure or a "forward like structure. Actuarial techniques used for pricing insurance polices are being employed to refine the pricing of financial derivatives. Likewise, economic techniques employed for pricing financial derivatives are found increasing use in insurance pricing. We also find that financial engineers are creating new types of instruments that can be used to hedge both financial risk and insurable risk and these new instruments are being marketed in both insurance markets and capital markets of developed countries. Many perceptive observers point out that insurance and financial derivatives are becoming increasingly interchangeable and their respective markets largely integrated. The economic justification for insurance risk securitization is that insurance risks are repackaged and sold to the capital market so investors can distribute their capital over these risks more efficiently than they could when the risks were contained in the original risky securities. This holds regardless of individual investor risk preferences or wealth. As long as this increase in efficiency is possible, insurance risk securities should continue to proliferate in the capital markets. The effects of more efficient risk transfer and risk sharing will manifest themselves in the form of more insurance coverage of assets, better insurance pricing, and lower capital costs for insurers and reinsurers. .
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Risk Management

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Risk Management

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Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Birds view of Risk

Insurance Risk V/S Altenaytive Risk Transfer

Pure & Speculative Risk

Dynamic & Static risk

Insurance Risk V/S Altenaytive Risk Transfer

Subjective & Objective risk

mathematical model for calculating the value of an option.

Insurance Risk V/S Altenaytive Risk Transfer

Insurance as Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Limitations to the Benefits of Insurance

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Alternative Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

The "Four C's" of ART

Insurance Risk V/S Altenaytive Risk Transfer

Top Five Myths of the Alternative Market

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Advantages of ART market

Insurance Risk V/S Altenaytive Risk Transfer

ART Market around the World

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

The Economics of Insurance Securitizations

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

The Economic Basis of Insurance Risk Securitization

Insurance Risk V/S Altenaytive Risk Transfer

INDIAN SECURITISATION MARKET : A SCENARIO ANALYSIS

Motive for securitisation

Nature and form of credit enhancements

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

The Obstacles & Policy recommendations

Lack of Investor Appetite

Insurance Risk V/S Altenaytive Risk Transfer

Catastrophe risk bonds

Insurance Risk V/S Altenaytive Risk Transfer

Catastrophe bonds catches fire

Insurance Risk V/S Altenaytive Risk Transfer

Pros & Cons of Cat Bonds

Insurance Risk V/S Altenaytive Risk Transfer

The disadvantages of catastrophe bonds include the following:

Insurance Risk V/S Altenaytive Risk Transfer

Securitization to be high growth business, says S&P

Insurance Risk V/S Altenaytive Risk Transfer

Insurance Risk V/S Altenaytive Risk Transfer

The Twenty-First Century

Regulatory Risks and Opportunities

Hedge your price risk

Insurance Risk V/S Altenaytive Risk Transfer

Methodology of hedging through futures

Insurance Risk V/S Altenaytive Risk Transfer