Most people are familiar with the traditional forms of insurance: home, life, auto, fire and more recently, disaster insurance. What you may not be familiar with is “Portfolio Insurance.” These are the non-traditional and non-insurance forms – products sold by the industry, some of which involve the use of derivatives.
When primary insurers sell a policy to a business or an individual, they depend on the total pool of premium receipts to cover losses incurred by policy holders. If the actuary has done his or her job correctly, the incomes from premiums will not only cover clients’ losses, but will, in addition, pay the insurers’ expenses and, hopefully, produce a profit. However, as demonstrated by the recent confluence of disasters, beginning with hurricanes along the Gulf and Atlantic coasts, and culminating with the destruction of millions of acres by fire in the West, events do not always occur at predicted rates. These unexpected catastrophes wreak havoc with insurer’s reserves and, as a consequence, give rise to the re-insurance industry.
NON-TRADITIONAL AND NON-INSURANCE PRODUCTS
Re-insurers serve the insurance industry in the same way that primary insurers serve their clients – they indemnify an insurance company against loss. In so doing, they are engaging in traditional insurance activity and spreading the risk around. Some re-insurers also engage in certain types of non-insurance and non-traditional activities.
Non-insurance transactions include the underwriting of Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO). These highly leveraged instruments are referred to as derivatives, and are primarily aimed at maximizing financial returns sometimes at the cost of magnifying the risk. Indeed, they were responsible, to a large degree, for the recent financial disaster.
Examples of non-traditional insurance, on the other hand, are catastrophe bonds (cat-bonds) and insurance linked securities (ILS). Cat-bonds are securities issued by insurers through investment banks and pay handsome premiums to investors if no loss occurs to the underlying assets. However, in the event of catastrophic loss, the bond principle is relinquished by the holder and the insurer uses the bond-purchase funds to help cover the loss. ILS, often referred to as Portfolio Insurance, is a means of hedging against the degradation of the value of a securities portfolio. It is these non-insurance and non-traditional insurance products that have recently given concern to regulators.
THE NEED TO MONITOR
The main source of regulation within the industry is the International Association of Insurance Supervisors (IAIS). The group determined in a November 2011 white paper, and a follow-up issued in July 2012, that although they see no systemic danger to the financial system by re-insurers engaging in traditional insurance activities, the same may not be true for those transactions deemed to be non-insurance or non-traditional insurance. The group’s concerns center on CDS, CDO, ILS and cat-bonds chiefly because of what is seen as a lack of collateralization for the underlying assets. Or as stated in the July, 2012 report:
The financial crisis has shown that, for example, CDS/collateralized debt obligations (CDO) underwriting without appropriate provisioning carries a considerable potential for systemic risk.
The report goes on to emphasize that while recognizing the potential for risk to the system from exposure to CDS and CDO, the fact is that because ILS and cat-bonds presently constitute such a small part of the re-insurance industry’s portfolio, these activities constitute no immediate threat. Again, from the report:
At this time, it is difficult to see how the marginal ILS market could give raise to systemic concerns, but going forward its growth and potential for systemic ramifications need to be monitored carefully.
That (conclusion) seems an eminently sensible approach to take with any financial market instruments and we don’t believe this monitoring would have any negative impact on the sector. In fact, the monitoring and supervision of ILS and cat bond market participants to ensure there is no risk of systemic interconnectedness emerging as the market grows can only be a good thing for participants and encouraging for investors in the sector.
So, it appears that, although the financial system is not immediately endangered by non-traditional insurance products, the potential does exist, particularly if there is a significant increase in exposure over time. The same cannot be said for non-insurance products from which the system has already sustained considerable damage.
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Jake Miller-Smits is a freelance writer and blogger who contributes articles on finance, real estate, insurance, financial regulation, energy investment and other similar topics. Lately he has taken a particular interest in oil investment; to learn more, view U.S. Emerald Energy, a firm which knows how to invest in oil.
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