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Risk Transfer Mechanisms: Prepared By: Kriti Angra Roll No. 04 Mba-As

Risk transfer mechanisms allow entities to transfer risks to other parties through various means like insurance, contracts, or securities. This includes credit derivatives that transfer credit risk of borrower defaults, and insurance-linked securities that transfer insurance risks. Classical products include securitization of loans/receivables and credit derivatives like credit default swaps. Alternative products provide off-balance sheet options like captives, contingent capital, catastrophe bonds, and multi-trigger products. The benefits include greater risk dispersion, market resilience to shocks, and capital optimization.

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83 views18 pages

Risk Transfer Mechanisms: Prepared By: Kriti Angra Roll No. 04 Mba-As

Risk transfer mechanisms allow entities to transfer risks to other parties through various means like insurance, contracts, or securities. This includes credit derivatives that transfer credit risk of borrower defaults, and insurance-linked securities that transfer insurance risks. Classical products include securitization of loans/receivables and credit derivatives like credit default swaps. Alternative products provide off-balance sheet options like captives, contingent capital, catastrophe bonds, and multi-trigger products. The benefits include greater risk dispersion, market resilience to shocks, and capital optimization.

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kritiangra
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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RISK TRANSFER
MECHANISMS

Prepared By:
Kriti Angra
Roll no. 04
MBA-AS
+
INTRODUCTION
 Risk Transfer:
It is an agreement under which some entity other than the one
experiencing the loss bears directs financial consequences. Risk
of loss may be transferred by one entity to another in a variety of
ways:-
 Insurance (transfer to an insurer under an insurance contract)
 Judicial (transfer to another party by virtue of a successful legal
action)
 Contractual (transfer to another party under contracts other than
insurance)
+
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 Risk transfer mechanisms comprise a two group of
financial instruments:
 Credit linked securities (credit derivatives) used to
transfer risks to another party in the form of borrowers
defaulting on their debt (i.e. borrowers are not repaying
debt).
 Insurance linked securities such as some ART products
and Catastrophe bonds are designed to shed risks from
underlying insurance risks.
+ CLASSICAL RISK
TRANFORMATION PRODUCTS
 Securitization: 

 The pooling of loans and/or receivables and selling that pool of


assets to a third-party, a special purpose vehicle (SPV).The risks
associated with that pool of assets, such as credit risk, are
transferred to the SPV. In turn, the SPV obtains the funds to
acquire the pool of assets by selling securities.
 When the pool of assets consists of consumer receivables or
mortgage loans, the securities issued are referred to as asset-
backed securities
 When the pool consists of corporate loans, the securities are
collateralized loan obligations.
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 Credit Derivatives:
 These allow investors to either acquire or reduce credit risk
exposure. Credit derivatives allow default risk to be transferred
without modifying the legal ownership of the underlying assets
and without having to refinance the loan.
 Credit default swaps (CDS) - protects the buyer from the
default of a company or sovereign borrower in return for a
periodic fee similar to an insurance premium.
 Synthetic collateralized loan obligation (CLO) - transfers the
credit risk exposure by buying credit protection for the same
pool of corporate loans.
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 Insurance:

 It is a risk transfer mechanism enabling a firm to transfer


the loss arising from some specific (risks), peril(s), or
hazard(s) from the equity holders of the insurance
purchaser to the equity holders of the insurance provider.
 The process by which an insurance company assumes risk
thus is known as underwriting, and the lead insurer is
called the lead underwriter.

 
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 Reinsurance:

 It is insurance protection purchased by insurance


companies.
 To hedge portfolios of insurance risks that exceed their
retention levels
 Facultative agreements- which are intended to cover
individual risks.
 Treaty agreements- which are intended to cover portfolios
of risks.
+
ALTERNATIVE RISK TRANSFER
PRODUCTS
 Captives:

 An insurance or reinsurance vehicle that belongs to a


company or group of companies that is not active in the
insurance industry itself.
 Insures the risks of its parent company.
 An instrument for self-financing risks.
+
 Contingent Capital:
 Is a pre-loss alternative risk transfer product that enables
insurance or reinsurance company with the possibility to
issue securities such as equities and bonds and structured
securities such as catastrophe bonds.
 Is low-cost off-balance sheet alternative that provides
conditional coverage upon the occurrence of some
triggering insurable event.
 Provides Insurers and reinsurers with the right, but not the
obligation, to issue specified security.
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 Insurance Derivatives:
 Financial derivatives that are used for insurance risk
hedging.
 Enablesinsurance and reinsurance companies to transfer
insurance risks to capital market investors and serve as a
complement to traditional reinsurance.
 Includefutures, options, catastrophe swaps and industry
loss warranties.
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 Sidecars:

 Similarities to cat bonds and traditional reinsurance and


can be used as a supplement to both.
 Used as a temporary vehicle to ease capacity constraints
or allow a firm to write more business than it would
otherwise.
 For example, sidecars were widely used to provide
temporary capacity for the US catastrophe market in the
aftermath of Hurricane Katrina.
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 Catastrophe Bonds:
 Risk-linked securities that transfer a specified set of risks
from the sponsor to capital markets investors through a
fully collateralized special purpose vehicle (SPV).
 Catastrophe bonds are written on the basis of predefined
natural catastrophes, typically an earthquake, a hurricane
or a wind storm.
 The SPV issues floating-rate bonds of which the principal
is used to pay losses if specified trigger conditions are
met.
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 Finite Risk:
Based on the spreading of individual risks over time.
 Key features Of Finite Risk are:
 Assumptions of limited risk by insurer.
 Multi-year contract term.
 Sharing of result with client.
 Depends on tax regimes and regulatory conditions.
 Strong Demand for solutions that combine finite and
traditional insurance elements
+  Types (Past)
 Loss portfolio transfers (LPTs)
 Policyholders transfer outstanding claims reserves to
the insurer.
 Retrospective excess of loss covers (RXLs)
 Offer broader spectrum of cover than LPTs.
 No transfer of outstanding claims reserves.

 Types (Present)
 Financial Quota share reinsurance (FQR)
 Prospective excess of loss covers (PXLs)
+  Integrated multi-line/multi-year products (MMPs):
Combines different categories of risk in one product.
 Key features of MMPs are:
 Bundling of different categories of risk over several
years
 Allow substantial risk to be transferred.
 Stabilization of risk costs.

 Hurdles for slow growth because of high transaction


costs.
 Credit risks is existent.
+
 Multi-trigger products (MTPs):

Key Features are:


 Two triggers for claims to be paid are:-
 An insurance event
 A non-insurance event

Key benefits are:


 Protection provided from disaster scenarios and price
falls in equity or bond markets in the same financial
year.
 Price advantage.
+  
BENEFITS OF RISK TRANSFER
MECHANISMS
 Greater dispersion and improved distribution of risk
 The arrival of new non-bank players has resulted in greater risk
dispersion and increased market efficiency.
 Banks themselves may buy risk.
 Resilience of the system to shocks e.g.- General Motors
 Capital optimization

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