FMI week 11 Insurance and CDS
Insurance
transfer of pure risk to an entity that pools the risk of loss and provides payment if a loss occurs. In return, insurer receives a fee called risk premium.
Pure risk: only loss or no loss
Speculative risk: loss, no loss or gain
Three types of insurance
General insurance policy
provide variety of risk products such as houses, vehicles, travels
Protection against
no investment component. no positive return
direct loss: damage
Indirect loss: loss of profit/increase of expense after a direct loss occured.
consequences of legal liability: up to the limit of liability if insured is judged responsible.
Health insurance policy
protection against medical costs associated with illness and injury
no investment component.
AU government transfer risks by placing levy surcharge for wealthy people, offload risks with private insurance.
Life insurance policy
purpose: provide financial support to dependent in the case of premature death
three types of policy
Term life insurance: pure life insurance for specific periods.
Whole life insurance: cover all life, keep paying for premium. Have investment component: can withdraw at particular age. Incentivise people for long term investment.
Business overhead insurance:
may have investment components. accumulate cash value and allow to withdraw to turn expenses to accumulated assets.
Insurance companies
Make money through collect premium and investment income.
pricing of insurance
Claim side: consider how likely people will make a claim, magnitude of loss.
Investment side: investment opportunities. if high interest rate, then lower policy rates to get larger market to invest.
Life insurance: invest in long term products.
General insurance: invest in short term and marketable products due to uncertain nature.
Objective risks
deviation between actual losses and expected losses
accurate prediction functions insurance mechanism
ways to reduce objective losses
The law of large numbers: number of insured increases, deviation decreases.
Underwriting: selection and classification of insurable risk
Co-insurance: loss sharing provision
Restrictive covenants: legal obligation imposed on contract.
Reinsurance: transfer insured risks to another insurance company.
Regulations
insurance industry regulated by ARPA, monitor capital reserves and liquidity
ASIC regulates legislative requirements, and licensing.
Issues in insurance industry
Adverse selection
Moral Hazard
Viability
Complexity
Patent
Securitisation of risk
Credit Default Swap(CDS)
Contract provides insurance against the risk of a default . Derivative contracts, value depends on value of corporate bonds.
Process: buyer bought bonds from a company(reference entity) and a CDS => total face value of bonds is notional principle => buyer makes periodic payments until end of life or default(credit event) occurs
CDS vs insurance
similar to insurance if buy underlying bonds
if not buy, then speculate(naked CDS), involves speculative risks rather than pure risk.
American International Group(AIG) nearly bankrupt during GFC due to not hedging risks and increased collaterals. Rescued by US government with taxpayers money because too big to fail.