Financial Risk Reporting of Insurance Companies in the UK and India - Thesis Example

Topic Financial risk reporting of insurances companies in UK and India. Order 224119 Topic Financial risk reporting of insurances companies in UK and India. Insurance Insurance is defined as a co-operative device to spread the loss caused by a particular risk over a number of persons who are exposed to it and who agree to ensure themselves against that risk. Risk is uncertainty of financial loss. Every risk involves the loss of one or other kind. The function of insurance is to spread the loss over a large number of persons who are agreed to co-operate each other at the time of loss. Oxford Dictionary of Business define insurance as "A legal contract in which an insurer promises to pay a specified amount to another party, the insured, if a particular event (known as the peril), happens and the insured suffers a financial loss as a result. The insured part of the contract is to promise to pay an amount of money, known as the premium, either once or regular intervals." Insurance Risk "Insurance is a device to share the financial losses which might befall on an individual or his family on the happening of special event" (Kaur n.d. p.4). The event can be death of a bread-winner to the family in the case of life insurance, marine-perils in marine insurance, fire in fire insurance and other certain events in general insurance, e.g, theft in burglary insurance, accident in motor insurance, etc. These events may occur any time within the insured period. The insurer has to provide a fixed amount or indemnify the amount of occurred due to the insured perils. Hence, insurers bear a great risk of paying huge amount of fund at any time if the insured peril is occurred. As large as the insured amount and the probability of happening insured peril, the Insurance Risk for insurers is large. Reinsurance Reinsurance is an arrangement whereby an original insurer who has insured a risk insures a part of that risk again with another insurer, that is to say, reinsures a part of the risk in order to diminish his own liability. According to the Oxford Dictionary of Business, "the passing of all or part of an insurance risk that has been covered by an insurer to another insurer in return for a premium. The contract between the parties is usually known as a reinsurance treaty. The policyholder is usually not aware that reinsurance has been arranged as no mention is made of it on the policy." Advantages of Reinsurance 1. The original insurer can accept the risk to the extent of his limit. In absence of reinsurance, a person desiring a large amount of insurance will have to take a number of policies from several insurers. The reinsurance contract makes it possible to purchase only one policy from an insurer. 2. Reinsurance makes it possible to accept each risk for the very amount desired by the proposer and to transfer the excess above the 'retention limit' to another insurer. 3. The reinsurance gives the benefit of the greater stability resulting from a widespread of business. By accepting many risks and scaling down, by reinsurance, all those that are larger than the normal carrying capacity of the insurer justifies, certainly in business is substituted for uncertainty through the better application of the law of average. 4. The insurance makes stability in underwriting and consistency in underwriting results over a period. 5. It provides a safeguard against serious effects of conflagration. 6. The reinsurance has the effect of stabilizing income and losses over a period of years. Capital Market The capital markets consist of the markets in which the intermediate and long-term securities of individuals, business firms, and governmental units are issued and traded. Capital markets are frequently subdivided into three parts-the bond market, the mortgage market, and the stock market. On the other word, capital market is the market where "long-term capital is raised by industry and commerce, the government, and local authorities" (Barclays Capital-Campus Recruitment, n.d.). The Glossary of Capital Market states that "stock exchanges are also part of the capital market for the shares and loan stocks that represent the capital once it has been raised" (TUTOR2U), Securitization At present world, securitization is one of the most important innovations. We can get a clear idea about securitization by the help of following explanation of securitization, which are provided by various authors and organigations. In the broad sense, securitization means "bundling or repackaging of rights of future cash flows for sale in capital markets"(Sankarreddy, December 2004). The repacking provides a more efficient allocation of risk. This process can be costly, but evidently the reallocation is valuable enough to make it worthwhile. BNET Business Dictionary (n.d.) states that "the securitization process involves the isolation of a pool of assets or rights to a set of cash flows and the repackaging of the asset or cash flows into securities that are traded in capital markets." The era of securitization began in the 1970s with the securitization of mortgage loans by the government sponsored enterprise (GSEs) Fannie Mae, Ginnie Mae, and Freddie Mac. "The Federal government creates these agencies with the objective of facilitating home ownership by providing a reliable supply of home mortgage financing" (Cowley and Cummins, 2005). The Dutch regulator De Nederlandsche Bank defined securitization in 2003 as: "Securitisation is the process whereby non-tradable assets such as mortgage loans and corporate loans are pooled and converted into securities. Securitisation is mostly done through separate legal entities, often called special purpose vehicles (SPV's) and involves the sale to the SPV of financial assets by their original owners, the originators. To fund their purchases, SPV's issue asset backed securities (ABS) whose repayment and interest payments are made from cash flows generated by securitised assets." Structure of Securitisation Cox, Fairchild and Pedersen, provides that "The securitization technology applies to many kinds of risk. In asset and liability securitization the common structure generally involves four entities: retail customers, a retail contract issuer, a special purpose company, and investors. We can see the following four entities in case of catastrophe risk bonds: 1. Homeowners who buy policies from an insurer. 2. The insurance company that issues the homeowners policies (that is, the retail contracts) and buys reinsurance from a special purpose reinsurer (that is, the special purpose company). 3. The special purpose reinsurer that issues the reinsurance and sells bonds 4. Investors who buy the bonds. " (p.6) Discussion on Insurance Risk Securitisation The specialist on Insurance Risk Securitization has provided different complement about this sector. Generally, through various books and articles they express their opinions. These opinions include the advantages, uses, aspect and limitations of insurance risk securitization. "The Chicago Broad of Trade launched options on natural catastrophes (cat spreads) in 1995 and catastrophe-linked bonds (cat bonds) have been issued since 1997. These innovative financial instruments are the response to the traditional insurance and reinsurance market's inability to deal with highly correlated risks. Say for example, simulations conducted by modeling firms suggest that damages caused by a major hurricane in Florida could be at least $75 billion and those due to an earthquake in California could exceed $100 billion. With prospective event-losses easily exceeding $50 billion, the capitalization of the insurance and reinsurance industry is at issue. Estimates of total capital and surplus of U.S. insurers and international reinsurers are approximately $300 billion and $100 billion respectively. Though such type of catastrophic losses are large enough to place the insurance industry under severe stress, they are lower than one standard deviation of the daily value traded (about $130 billion on average) in the U.S. capital markets" (MAHUL, 1 August 2001). The article on Securitization of Life Insurance Assets and Liabilities by J. David Cummins includes that "since 1970, trillions of dollars worth of mortgages have been securitized, and new issue volume reached $1.5 trillion by 2002" (Cummins, 3 January 2004, p.2). Both the parties who carrying the insurance risk and who buy this risk are increasing their interest in securitization process of insurance risk as well as other types of risks which can be securitized such as weather, credit risks, etc. The process of securitization of risks into a tradable commodity generated the most significant trend of our times, i.e., these products are dominating the capital markets. After contracting an insurance policy it is converted into a commodity, that is the policy is securitized and it become a financial instrument that can be bought and sold in the capital market. "There is a general agreement among various commentators that in time to come, we will see greater application of the securitization process to convert and market risks. According to Peter Drucker, who wrote an article in The Economist, and he saw, in his own foresightful wisdom, the possibility of pooling and transfer of exchange rate risks by securitizing them. Mr. Al Hageman, the Citibank's global securitization head, very recently wrote of his experience with securitization over last 20 years and he say increasing trend towards much purer forms of risk transfer in securitization. Thus, securitization as it is emerging would have more elements of risk transfer than financing" (Frankel, and LaPlume). That is, the main intention of the insurers is not allocating fund through securitization rather the insurers try to diminishing the insurance risk, so that they can meet up the great insured peril. The securitization process makes them capable to face any amounted insurance demand. In traditionally the primary insurers get protection from large insurance risk by process of reinsurance. The reinsures who are specialists and well established in the insurance market even though achieve a special spread of risk and in a result, they are capable to bear catastrophe risks (such as floods, hurricanes, tropical storms, earthquakes, wildfires, volcanic eruptions, etc.) those are undiversifiable to the primary insurers, but the transaction costs associated with reinsurance, that is premiums, are high. On the other hand in consequence of catastrophic insurance policy many reinsurers may become insolvent or seriously impaired if the insured peril is occurred. Therefore the reinsurers may unable to continue insuring the same volume of insurance business. "High premiums as well as the fact that catastrophe losses exhibit little correlation with capital market indices, has attracted considerable activity in Wall Street in searching for new instruments that securitize catastrophe risk. The high transactions costs of reinsurance offers potential for hedging instruments to be offered to primary insurers that are both competitive with current reinsurance as well as investors get high rate of return in compare to other instruments in the capital markets. Now-a-days, many players are talking of catastrophe risk being a new "asset class" and new instruments such as catastrophe options and catastrophe bonds are starting to appear" (Doherty, December 1997, p.1). Day by day, the markets for insurance risk and capital are converging; "Convergence can be defined as the process of moving towards union or uniformity. But the true meaning is that two separate markets have started performing the same function. Initially driven by the risk transfer needs of the insurance industry, and the diversification benefits perceived by the capital markets, the convergence of insurance and capital markets is now accelerating" (BNET). "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 investor's point of view, there are compelling arguments to include securitized 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" (Cole, and Chiarenza, July 1999). According to Cummins, and Weiss (2004), "securitization provides a mechanism whereby contingent and predictable cash flows streams arising out of a transaction can be unbundled and traded as separate financial instruments that appeal to different classes of investors." Since these financial instruments provide a reasonable return to the investors, these are popular to the investors. "Another general benefit is provided by the securitization is creation of new classes of securities that appel to investors with different appetites for risk. In the limit, securitization can create non-redundant securities that enable investors to improve portfolio efficiency by increasing the level of risk. Securities mortality, catastrophic property, and longevity risk are non-redundant because the covered events are not otherwise traded in capital markets. Securities based on these risks also are likely to have relatively low covariance with market systematic risk (which is expressed by Beta and average systematic risk for the market is 1), making them even more valuable for diversification purposes. Because this diversification reduces the total systematic risk or average Beta of the portfolio" (Cummins, 3 January 2004, p.12). "Thus, investors can improve portfolio efficiency by adding these securities to their portfolios" (Epetimehin, 5 February. 2008). In spite of the relatively small volume of insurance transactions to date, securitization has significant potential to improve market efficiency and capital utilization in the insurance industry. Because of the securitization policy, now-a-days the insurance companies are more capable to make their position effective and strong in the financial system. This strong position has enabled insures to compete more effectively with other financial institutions, i.e., in increasing return on equity and improving other matters of operating performance. Insurers can offer more profitable and secured policy in the financial markets which are attracted to the financial investors. "With the help of securitization insurers get the opportunity to unlock the embedded profits in blocks of insurance presently carried on balance sheet and to provide an alternative source of financing in an industry where traditional financing mechanisms are often restricted due to regulation." (Goliath, 01 January 2005). It also provides a mechanism to the insurers to create different kind of insurance policies by utilizing equity capital more efficiently rather than using investment management, policy servicing, and risk bearing functions. Hence the insurance companies can separate the insurance policy origination function from the investment management, policy servicing, and risk bearing functions. Thus, the companies can minimize their risk in a significant portion. Since the securitization of insurance risk provide a new and significant source of finance as well as improve liquidity and transparency, the insurers get new sources of risk capital to make protection against adverse underwriting more efficiently in compare to traditional techniques such as reinsurance and letters of credit. Candidates for Securitization As like as other companies the balance sheet of an insurance company contains the total assets and liabilities of that company. There are some long term assets and liabilities as well as short term assets and liabilities. Normally these assets and liabilities are showed in the balance sheet at present value, i.e., current market price of those assets and liabilities. For instance, if a plant is purchased at $100,000 now and the life of the plant is 10 years, then after 2 years the value of it will be $80,000 and at the balance sheet the plant will be valued at $80,000 not at $100,000. "In principle, any account or any series of cash flows which represent estimates of the present values of cash flows inherent in each asset and liability account is a candidate for securitization (Cowley and Cummins, 2005). Conclusion The securitization process provides almost every benefit to the primary insurers, which can be achieved by reinsurance. In addition, it removes the disadvantages of the reinsurance. Through securitization the insurers can generate huge amount of fund as well as they can reduce the insurance risk in significant portion. On the other hand, securitization of insurance risk provides the opportunity for insurance companies to enter into the capital markets. The financial investor also benefited by investing in those financial instruments, which are created through securitization process. Because these financial instruments has the lower systematic risk in compare to other financial instruments in the markets. All these performance of securitization brings the goodwill for the respective insurance company. Hence, the insurers feel encourage in securitization rather than going into the reinsurance process. References Barclays Capital-Campus Recruitment, (n.d.). Glossary, Capitalmarket, http://www.barcap.com/sites/v/index.jspvgnextoid=fc4a5bec3865c010VgnVCM1000002e14480aRCRD BNET Business Dictionary, (n.d.). Securitization of Life Insurance Assets and Liabilities, http://resources.bnet.com/topic/securitization.html BNET, Insurance Risk - Securitisation, Enterprise Risk Management http://jobfunctions.bnet.com/whitepaper.aspxdocid=65074 Cole, Joseph., and Chiarenza, Anthony (July 1999). The best of both worlds, RisPublications. http://www.financewise.com/public/edit/riskm/insure/ins-securit.htm Cowley, Alex. Cummins J. David. (2005) Securitization of Life Insurance Assets and Liabilities. Journal of Risk & Insurance 72 (2) , 193-226 doi:10.1111/j.1539-6975.2005.00121.x Cox, H. Samuel., Fairchild, R. Joseph. and Pedersen, W. Hal. Actuarial And Economic Aspects of Securitization of Risk, Structure of Securitization. http://www.casact.org/pubs/dpp/dpp99/99dpp19.pdf Cummins, J. David. (January 3, 2004). The Wharton School. Securitization of Life Insurance Assets and Liabilities,PAGE-2, fic.wharton.upenn.edu/fic/papers/04/0403.pdf Cummins, J. David. And Weiss, A. Mary. (2004). "Securitization of Life Insurance Assets and Liabilities" FINANCIAL INSTITUTIONS CENTER, http://fic.wharton.upenn.edu/fic/papers/04/p0403.html Doherty, A. Neil. (December 1997). Financial Innovation in the Management of Catastrophe Risk. Wharton School, http://fic.wharton.upenn.edu/fic/papers/98/cat02.pdf, Epetimehin, Festus. (5 February. 2008). Insurance development and the capital market, Publishers of Nigerian Tribune, http://www.tribune.com.ng/05012008/Management.html Frankel, Tamar. and LaPlume, Joseph. Law of Insurance risk securitization http://www.vinodkothari.com/riskseclawarticle.htm GOLIATH, (01 January 2005). Securitization of life insurance assets and liabilities. http://goliath.ecnext.com/coms2/gi_0198-229832/Securitization-of-life-insurance-assets.html http://www.du.ac.in/course/material/ug/ba/bankinsu/unit4.pdf Kaur, Satvinder. (n.d.). Life Insurance, 4.2.1.3 Nature of Insurance. Mahul, Olivier (1 August 2001). American Journal of Agricultural Economics. Managing Catastrophic Risk Through Insurance And Securitization. http://www.allbusiness.com/accounting-reporting/assets/810659-1.html Sankarreddy. Dilip, (December 2004) Risk Securitisation: A Few Notes, Getting started: http://www.dilipsankarreddy.com/riskSecuritisation.htm TUTOR2U, Accounting Glossary-c, Capital market, http://tutor2u.net/newsmanager/templates/a=1375&z=82 Read More