Securitization techniques are widespread in life and non life risks. They involve the financial markets to cover reinsurance risks whereas the so-called traditional reinsurance relies on shareholder’s equity or funds to achieve the same purpose.
Securitization transforms financial assets into negotiable securities on the capital market. It developed through the evolving of financial techniques and stock markets. It is mainly used in the most advanced countries where the financial system is highly developed.
Securitization: functionning in the insurance industry
1. Establishment of a special purpose vehicle
In a typical construction, the process starts with the creation of a predefined or ad hoc legal entity called Special Purpose Vehicle (SPV). The SPV is not a reinsurance company.
2. Risk transfer to SPV
The insured or reinsured transfers its risks to the predefined legal entity. A premium is paid under this contract or transfer.
3. Issuance of securities by the SPV
The SPV fully finances its exposure to these risks by issuing a debt or another financing mechanism. The issuance of securities is targeting investors on the financial markets.
The funds raised are reinvested in financial products that will be deposited in a guarantee fund. The latter will transfer the interests generated to the ad hoc entity or to the special purpose vehicle. Finally, in the event of a swap, the interests generated by the investments are exchanged for a fixed rate.
Simplified pattern describing the process of securitization
Securitization [4] is a satisfactory alternative for the protection of shareholder’s equity. This is one of the reasons why life insurance and reinsurance make recourse to it. It improves the return on equity through better use of capital. Moreover, tax benefits can also be reaped from this process.
In non life reinsurance, it is the guarantee of natural catastrophe risks that has been most successful in this segment.
Securitization in life insurance
In life insurance, securitization offers three advantages. It makes it possible:
- to obtain a funding source transforming the intrinsic value of intangible assets (present value of future profits, acquisition costs, etc.) in monetary value,
- to mitigate the requirements of the regulations in terms of minimum capital,
- to face the risks of a catastrophic nature, such as epidemics or risk of increased longevity.
Unlike non life insurance, the majority of bonds issued in the life sector are designed to obtain financing. However, catastrophe bonds issued in life insurance, (like epidemics), are not financial instruments.
They are similar, in this sense, to catastrophe bonds issued in non life insurance. They transfer to investors the extreme risk held in the portfolio of the ceding company.
In the case when mortality remains in the pre-estimated bracket, investors receive the maximum interests provided then the principal in the long run. In the event of an increase in mortality, interests are reduced by the losses sustained that may even affect the principal.
Securitization in non life insurance
Due to the volatility of non life business, alternative reinsurance [5] provides many solutions of risk transfer to the stock market or capital management. It is primarily for protection against extreme risks that non life insurers and reinsurers appeal to financial markets by creating new assets: Insurance Linked Securities (ILS).