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A daily selection of business terms and their definitions / application.

Term: Corporate Capital

What is Corporate Capital?

Corporate capital is the mix of assets or resources a company can draw on in financing its business. Corporate capital results from debt and equity financing. In deciding on and managing their capital structure, a company’s management has important decisions to make on the relative proportions of debt and equity to maintain.

Understanding Corporate Capital

A corporation has several options for sourcing capital. Equity capital is one broad source with multiple components. Common shares and preferred shares issued by the company, as well as additional paid in capital, are part of a company’s equity capital. These types of equity allow outside investors the opportunity to take partial ownership in the company. Retained earnings, accumulated profits that have been reinvested in in the business instead of paid out to shareholders, are another form of equity.

Debt capital is money borrowed from another entity that is due to be paid back at a later date, typically with additional interest. Borrowings include fixed income securities such as loans, bonds, and notes payable. A company’s capital structure might also include hybrid securities such as convertible notes.

The decisions a company makes with respect to its corporate capital can affect both its access to and cost of financing, tax liability (because of the favorable tax treatment, or tax shield, that debt receives), its credit rating, and ultimately its liquidity. In coming up with an optimal mix of debt and equity for its corporate capital structure, companies generally give significant weight to how much flexibility, in maintaining ownership control, financing, and managing the business, a given structure will provide them.

KEY TAKEAWAYS

  • Corporate capital includes any assets a company may use to finance its operations, and it may be derived through debt or equity sources.
  • Capital structure is the particular mix of debt and equity that make up a company’s corporate capital.
  • How a company manages its corporate capital can reveal a lot about the quality of its management, financial health, and operational efficiency.

Managing Corporate Capital

How a company manages its corporate capital can reveal a lot about the quality of its management, financial health, and operational efficiency. It’s also an important part of valuation. For example, a company whose retained earnings are growing might signal one with high growth prospects, for which it expects to use those accumulated earnings. It might signal one operating in a capital-intensive sector that needs to retain most of its profits rather than paying them out as dividends or returning them to shareholders via buybacks. It might also indicate a company with a lack of profitable investment opportunities. For these reasons, retained earnings should always be reviewed in combination with other metrics of a company’s financial health.

Key ratios to calculate for these purposes are total debt to equity, and long-term debt to equity. Both can provide a picture of a company’s financial position by revealing how much financial leverage or risk is present in the capital structure. The level and trend of the ratios over time is important. It is also important to assess how they compare to other companies operating in the same industry. Overly leveraged capital structures can point to developing or potential liquidity problems. Under leveraged structures might mean a company’s cost of capital is too high.

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Term: Prepaid Cards Processor

What is a Prepaid Cards Processor?

A prepaid cards processor is a company that processes transactions for prepaid payment cards. Prepaid card processors are responsible for processing transactions for prepaid credit or debit cards, gift cards, payroll cards, and other payment cards that are considered secured by the front-loading of money.

KEY TAKEAWAYS

  • A prepaid cards processor works with prepaid cards to allow a cardholder to conduct transactions without the use of cash, but limits the size of the transaction to the amount of money available on the card.
  • Prepaid payment cards are typically more customizable than cards issued by banks and other financial institutions. This is because the needs of the organization offering the card can vary greatly.

How a Prepaid Cards Processor Works

A prepaid cards processor works with prepaid cards to allow a cardholder to conduct transactions without the use of cash, but limits the size of the transaction to the amount of money available on the card.

Prepaid cards are secured cards, meaning that the value of the card is limited to the amount of cash that has been loaded onto the card’s account. For example, a gift card may have a maximum value of $50 if only $50 has been loaded to that account at the point at which the card was activated. Requiring prepayment before activation limits the exposure of the issuing company to a precise value, unlike an unsecured card linked to a line of credit. Some types of prepaid cards also have a penalty fee for disuse or use past a set time limit.

Prepaid card processors are unlikely to provide point-to-point encryption (P2PE) because they do not provide a direct link between the point-of-interaction, such as the card terminal at a merchant, and the processor. Instead, prepaid card processors are responsible for the payment processing component of the transaction. This requires the processor to record purchase information and manage the account balance of the prepaid card, as well as manage chargebacks, returns, and payment disputes.

Examples of Prepaid Cards

Examples of prepaid cards include gift cards and phone cards but can also be used in government aide programs instead of sending a periodic check. Prepaid cards are often re-loadable and may require the card holder to set a pin number in order to use it and minimize theft.

Keep in mind that most prepaid cards are a “use it or lose it” scenario. This means that any value left on the cards and never used, benefit the issuer of the prepaid cards. Even if a prepaid card only holds a few dollars, it makes wise sense to use all of its value before throwing it away.

Advantages and Disadvantages of a Prepaid Cards Processor

Prepaid payment cards are typically more customizable than cards issued by banks and other financial institutions. This is because the needs of the organization offering the card can vary greatly. Large credit card processors, such as VISA, are frequently involved in this line of business, though smaller businesses may also provide prepaid card processing services.

Prepaid cards through a prepaid cards processor can be a convenient way for organizations to procure funds for their clients or recipients, but they do carry a risk of being misused or even stolen. For instance, because the value of a prepaid card is carried entirely within the card, if it is stolen or given to the wrong individual, the value may not be able to be recovered.

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Term: Deposit Broker

What is a Deposit Broker?

A deposit broker is an individual or firm that facilitates the placement of investors’ deposits with insured depository institutions. Deposit brokers offer investors an assortment of fixed-term investment products, which earn low-risk returns. An individual or firm may still be considered a deposit broker even if they do not receive a fee or direct compensation.

KEY TAKEAWAYS

  • Deposit brokers offer investors an assortment of fixed-term investment products, which earn low-risk returns. An individual or firm may still be considered a deposit broker even if they do not receive a fee or direct compensation.
  • A deposit broker is similar to a stockbroker, but whereas a stockbroker deals only in equity, a deposit broker can offer alternative investment opportunities. Another significant difference is that stockbrokers must pass the Series 7 to sell securities, whereas deposit brokers may not need regulatory approval to market fixed-term securities.
  • Deposit Brokers sell brokered deposits, which are usually large-denomination deposits first sold by a bank to a brokerage or deposit broker, who then divides it into smaller pieces for sale to its customers.

How a Deposit Broker Works

A deposit broker is similar to a stockbroker, but whereas a stockbroker deals only in equity, a deposit broker can offer alternative investment opportunities. Another significant difference is that stockbrokers must pass the Series 7 to sell securities, whereas deposit brokers may not need regulatory approval to market fixed-term securities.

The term deposit broker often refers to an individual or firm that facilitates the placement of investors’ deposits with insured depository institutions.

Though deposit broker is a broadly defined term, financial institutions and their employees, trustees, and pension plan advisers are notably precluded from the definition.

What is a Deposit Broker Selling?

Deposit Brokers sell brokered deposits, which are usually large-denomination deposits first sold by a bank to a brokerage or deposit broker, who then divides it into smaller pieces for sale to its customers. Brokered deposits are one of two types of deposits that comprise a bank’s deposit liabilities, the second being core deposits.

Lending banks value core deposits for their stability. Core deposits monopolize on a bank’s natural demographic market and offer many advantages to financial institutions, such as predictable costs and a measurement of how loyal their customers are. Specific forms of core deposits include checking accounts and savings accounts made by individuals.

Examples of Deposit Broker

For example, if your lawyer or accountant introduces you to a bank, they are assisting the arrangements of deposits at this bank and are considered deposit brokers. This can be typical of an accountant or lawyer that has a practice, yet offers other financial products to its customers.

A depository institution can be an organization, bank or other institution which holds and helps in the trading of securities. The term can also refer to an institution that accepts currency deposits from customers.

Banks and Deposit Brokers

By accepting brokered deposits, a bank can access a larger pool of potential investment funds and improve its liquidity. For banks, liquidity is critical to survival. This improved liquidity can give banks the capitalization they need to make loans to businesses and the public. Under Federal Deposit Insurance Corporation(FDIC) rules, only well-capitalized banks can solicit and accept brokered deposits. Adequately capitalized ones may take them after being granted a waiver, and under-capitalized banks cannot accept them at all. Even if a bank is well-capitalized, overuse of brokered deposits can lead to bank failure and losses.

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Term: Limited Service Bank

What is a Limited Service Bank?

A limited service bank is any form of a banking business institution that is located separately from the bank’s main location. Banks may offer separate services from what they offer at their main facility, or between the other branches.

KEY TAKEAWAY

  • Some institutions are self-regulating and determine the types of services and products offered at their locations and the time frames in which they are available based off of their bank charter.
  • A limited service bank may have a separate location for taking deposits, where they do not allow their products and services to be sold. These are different from full-service banks, which offer all services and products across all locations.
  • Automated Teller Machines (ATMs) act a lot like limited service banks. Consumers can deposit and withdraw monies at ATM locations that are offsite from the main branch locations.

How a Limited Service Bank Works

A limited service bank can offer limited options by choice. Some institutions are self-regulating and determine the types of services and products offered at their locations and the time frames in which they are available based off of their bank charter. These types of banks may specialize in specific products, such as credit lines or personal loans, and may not wish to expand beyond those products across all locations.

They could be also limited by the laws in their state. These regulations are more common in the Midwest and Southwest of the U.S., where banks are more limited on the number of branches they can have that offer full services. This is to prevent a banking monopoly in more rural areas where communities could be better serviced by smaller institutions. These are called unit banks or unit states.

A limited service bank may have a separate location for taking deposits, where they do not allow their products and services to be sold. These are different from full-service banks, which offer all services and products across all locations.

Bank ATM

Automated Teller Machines (ATMs) act a lot like limited service banks. Consumers can deposit and withdraw monies at ATM locations that are offsite from the main branch locations. Users can also check their balances and even pay bills (mortgage or loans) from the ATM, and transfer funds from one account to another.

ATMs offer convenience for those traveling abroad. Making withdrawals in another currency often comes with additional fees like a “surcharge” and “foreign ATM” fees.

Example of a Limited Service Bank

For example, say that the hypothetical Money Bank, U.S. has 10 branches across Southeastern Pennsylvania. At every location you can make a deposit, cash a check and apply for a home mortgage. When they run a promotional offer crediting new account holders $20 towards ordering checks, the promotion runs throughout all of their 10 branches. A customer could walk into any branch and receive all the same services, at the same time. This is a full-service bank.

Now take the hypothetical U.S. Coin Bank, an Iowa-based bank that also has 10 branches across the state. When a customer goes to the branch in Cedar Falls, they can only cash checks if they are a current account holder. A customer who wants to apply for a mortgage with U.S. Coin Bank wouldn’t be able to do it at the Cedar Falls branch, but would instead need to travel to the Cedar Rapids branch to do so. Furthermore, they would need to travel to the branch in Carbon if they wanted to take out a credit card. This is an example of a limited service bank.

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Term: Reserve Maintenance Period

What is the Reserve Maintenance Period?

The reserve maintenance period is the time frame in which banks and other depository institutions must maintain a specified level of funds. It is a two-week period that begins on a Thursday and ends on a Wednesday. An assessment of overdrafts and corresponding charges also occurs during this time period.

Because the specified amount of reserve funds changes regularly, it is important for the institution to have an account at a reserve bank or a subsequent pass-through arrangement, in order to ensure that the appropriate funds are available. Vault cash can also be counted toward the reserve requirements for a given reserve maintenance period, but a pass-through arrangement or reserve bank balance is typically used to make up the shortfall between a bank’s available vault cash and its reserve requirement.

Understanding the Reserve Maintenance Period

In a pass-through arrangement, a bank satisfies its reserve requirement for a given reserve maintenance period by passing its reserve balance through the account of a correspondent bank or credit union. Eligible correspondent banks include National Credit Union Administration Central Liquidity Facilities, Federal Home Loan Banks, depository institutions or banking Edge Act and Agreement corporations with a master account at a Federal Reserve Bank. Otherwise, a bank may meet its reserve requirements by depositing reserve funds in its own Federal Reserve account.

Penalties for Failing to Meet the Reserve Requirements

To calculate whether or not a specific bank has adequate funds in its reserve account or pass-through account to satisfy the reserve requirement, the Federal Reserve uses the average of all the end-of-day balances of that institution’s master account throughout the reserve maintenance period. That means that a given bank’s reserve balance can fall below, or exceed, the requirement threshold on a given day without necessarily incurring a penalty. Institutions can make up for shortfalls by maintaining a higher balance on other days in the reserve maintenance period.

A penalty-free band exists that is equal to the reserve balance requirement, plus or minus a specific dollar amount. For banks and depository institutions that maintain their reserve balances directly with the Federal Reserve, the top and bottom thresholds of this band is $50,000 or 10 percent of the institution’s reserve balance requirement, whichever amount is greater. The institution must maintain an average balance greater than or equal to the bottom of this penalty-free band in order to fulfill its requirements in any given reserve maintenance period.

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Term: Fictitious Trade

What is a Fictitious Trade?

A fictitious trade is a trade that is booked with an execution date far in the future, and is adjusted to include the correct settlement and trade date when the transaction is completed.

How a Fictitious Trade Works

A fictitious trade is used in the processing of a securities transaction as a form of placeholder, and is found when open dates or rates are being used.

It also refers to a securities order used to affect the price of a security, but which does not result in shares being competitively bid for and no real change in ownership. Wash sales and matched orders are examples of fictitious trades. A fictitious trade is designed to give the impression that the market is moving in a certain direction, when in fact it is being manipulated by a broker.

Example of a Fictitious Trade

For example, two companies enter into a series of ongoing transactions whose values are based on an interest rate set each week. Because the interest rate can change from week to week, an open execution date is used for the transaction until the interest rate is announced. Two transactions are recorded. The first is a cash transaction with a settlement date (the same as the trade date); the second transaction has the same trade date, but with a settlement date for several weeks later. Each week, the second transaction is updated to include the correct interest rate and settlement date.

Improper Use of Fictitious Trading

UBS trader Kweku Adoboli was convicted of two counts of fraud in 2012 after his fraudulent trades led to losses of $2.3 billion when he was working in the London office. The losses were incurred primarily on exchange traded index future positions and were the largest unauthorized trading losses in British history. His underlying positions were disguised by employing late bookings of real trades, booking fictitious trades to internal accounts and the use of fictitious deferred settlement trades, explained the British Financial Services Authority (FSA). The FSA fined UBS AG (UBS) £29.7 million (about $40.9 million), the third largest fine the regulator had imposed in its history, for systems and controls failings that allowed an employee to cause substantial losses as a result of unauthorized trading.

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Term: Compulsory Convertible Debenture (CCD)

What Is a Compulsory Convertible Debenture (CCD)?

A compulsory convertible debenture (CCD) is a type of bond which must be converted into stock by a specified date. It is classified as a hybrid security, as it is neither purely a bond nor purely a stock.

A debenture is a medium- to long-term debt security issued by a company as a means of borrowing money at a fixed interest rate. Unlike most investment-grade corporate bonds, it is not secured by collateral. It is backed only by the full faith and credit of the issuing company.

In effect, an unsecured corporate bond is a debenture.

Understanding the CCD

A debenture comes in two forms – non-convertible and convertible:

  • A non-convertible debenture cannot be converted into equity shares of the issuing company. Instead, debenture holders receive periodic interest payments and get back their principal at the maturity date, just like most bondholders. The interest rate attached to them is higher than for convertible debentures.
  • Convertible debentures may be converted into the company’s equity after a set period of time. That convertibility is a perceived advantage, so investors are willing to accept a lower interest rate for purchasing convertible debentures.

The CCD is one form of the convertible debenture. The difference is that its owner must accept stock in the company when it matures rather than having the option of receiving stock or cash.

KEY TAKEAWAYS

  • A compulsory convertible debenture is a bond that must be converted into stock at its maturity date.
  • For companies, it allows for repayment of debt without spending cash.
  • For investors, it offers a return in interest and, later, ownership of shares in the company.

Debenture holders have no rights to vote as shareholders until their debentures are converted into shares.

For companies, the compulsory conversion of debentures to equity is a way to repay a debt without spending cash. It is payment in kind, consisting of repayment of principal and payment of interest.

The compulsory convertible debenture’s ratio of conversion is decided by the issuer when the debenture is issued. The conversion ratio is the number of shares each debenture converts in to, and can be expressed per bond or on a per centum (per 100) basis.

CCDs are hybrid securities, with some attributes of bonds and some like stocks.

There are two types of conversion prices. One limits the price to the equivalent of the security’s par value in shares. The second allows the investor to earn more than par value.

How CCDs Are Traded

CCDs are usually considered equity, but they are structured more like debt. The investor may have a put option which requires the issuing company to buy back shares at a fixed price.

Unlike pure debt issues, such as corporate bonds, compulsory convertible debentures do not pose a credit risk for the company issuing them since they eventually convert to equity. CCDs also mitigate some of the downward pressure a pure equity issuance would place on the underlying stock since they are not immediately converted to shares.

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Term: Brokered Market

What is a Brokered Market?

A brokered market involves agents or intermediaries in purchase and sale transactions to facilitate price discovery and transacting the execution.

Brokered markets often exist in areas of the economy where there is a certain level of expertise required to complete a transaction. In cases where members of the general public do not possess the necessary knowledge to facilitate transactions on their own, brokers, or agents/intermediaries, will be used. Brokered markets include all exchanges where listed instruments are traded, as well as markets for non-listed assets such as real estate.

The use of brokers as intermediaries between buyers and sellers aids market efficiency by fostering liquidity, reducing bid-ask spreads and boosting transaction volumes. Also, it’s important to note that brokers are not acting from their inventory. They are simple middlemen consummating a transaction between a buyer and a seller.

Understanding a Brokered Market

Brokered markets are the norm for most transactions, which can span the range from an investor selling 100 shares of a blue chip stock or a billionaire who wishes to buy a factory in a foreign country. In the former case, either the investor may sell his or her shares through a broker at a full-service brokerage, or online through a discount brokerage; a brokered market is used in either case, since the trade will be executed on a stock exchange. In the latter case, the broker would most likely be a specialist with in-depth knowledge of the country and the assets for sale therein.

Example of a Brokered Market

Let’s say a couple is looking to purchase their first home. They end up deciding on an area that is up and coming and fits within their budget. The couple will seek out and hire a real estate agent that is familiar with the area. The agent will learn about the desires of the couple for the home purchase, and then set about lining up showings of available homes.

Once the couple decide on the place they want to purchase, they will submit an offer to their agent, which the agent will in turn show the offer to the seller’s agent. If both sides agree to the price and terms, the transaction is made. The real estate agents brokered the trade and will receive a commission for their effort.

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Term: Interest Only (IO) Strips

Interest only (IO) strips are a financial product created by separating the interest and principal streams of a debt-backed security.

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Term: Sub-Pennying

What Is Sub-Pennying?

Sub-pennying is a practice where brokers, dealers or high-frequency traders jump to the front of the line in the National Best Bid and Offer (NBBO), which is the highest posted bid and the lowest posted offer for a trading instrument, by making a price improvement in 1/100 of a penny increments. This allows the transaction to be executed first and provides the best opportunity to capture the spread.

KEY TAKEAWAYS

  • When a market participant in an undisplayed market center – such as a dark pool – steps ahead of a displayed limit order by a fraction of a cent and captures the spread.
  • Retail brokers will take sub-pennying orders because they’re allowed to secure the best possible price for their clients, even if the trade is not on an exchange or ECN. And, the access fee is often included in a broker’s commission, which means that they’re incentivized to find orders that do not necessarily pay these fees.
  • The SEC introduced Rule 612 – or the Sub-Penny Rule – in 2005 to address these issues. In particular, the rule states that the minimum price increments for stocks over $1.00 must be $0.01, and stocks under $1.00 can increment by $0.0001.

HUnderstanding Sub-Pennying

Exchanges and electronic communication networks (ECNs) charge access fees to any market participant taking a displayed offer or hitting a displayed bid in exchange for providing liquidity. Participants who display the bid or offer are provided with a rebate in exchange for providing liquidity, which is capped at 0.3 cents per share by the Securities and Exchange Commission.

Sub-pennying occurs when a market participant in an undisplayed market center – such as a dark pool – steps ahead of a displayed limit order by a fraction of a cent and captures the spread. While the buyer in the situation actually receives a slightly better deal, the seller misses out on the opportunity to fill the order, and then the liquidity provider doesn’t receive any rebates.

Retail brokers will take sub-pennying orders because they’re allowed to secure the best possible price for their clients, even if the trade is not on an exchange or ECN. And, the access fee is often included in a broker’s commission, which means that they’re incentivized to find orders that do not necessarily pay these fees.

New Rules & Regulations

The SEC introduced Rule 612 – or the Sub-Penny Rule – in 2005 to address these issues. In particular, the rule states that the minimum price increments for stocks over $1.00 must be $0.01, and stocks under $1.00 can increment by $0.0001. The problem is that the rule only banned sub-penny quoting and not sub-penny trading, so the practice of sub-pennying persisted following the new rule.

In 2014 and 2015, the SEC introduced a study that called for the widening of increments—or ticks—at which smaller companies’ stock prices are priced to see if it helps improve market liquidity. A group of stocks in the study would also be subject to a controversial reform called the “trade at” rule, which would help drive more traffic on to exchanges and ECNs and away from alternative trading venues like dark pools.

Traders insist that these rules would be highly anti-competitive and have lobbied against them, which makes them unlikely to pass into law in the United States. Since the pilot study was commissioned, the “trade at” rule has largely faded into the background, particularly with President Trump’s opposition to new financial regulations.

Example of Sub-Pennying

Let’s a assume a stock is quoted at .75 x .76 when a retail investor is looking to sell her 1000 shares. While she is putting in her sell limit order at .75, a competing market maker has a hidden bid of .7510 for 1000 shares. When the customer submits the sell order, the hidden bid buys the 1000 shares and the customer is filled at .7510 on the 1000 shares, rather than .75 as shown on the screen.

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Term: Dalian Commodities Exchange

What is the Dalian Commodities Exchange?

The Dalian Commodities Exchange is located in Dalian, China and trades futures contracts on a wide variety of commodities. The exchange the largest trader of agricultural futures in the world.

Understanding the Dalian Commodities Exchange

The Dalian Commodities Exchange has been a key factor in the revitalization of Northeast China’s expansion as an international agricultural hub, in part due to the area’s strategic location with access to railroads and highways. The exchange performs several major functions, including providing venues for futures and options trading, developing and listing contracts, organizing and supervising trading, clearing, and settlement. Additionally, the exchange handles market surveillance and rule enforcement, formulating and implementing risk management rules, organizing marketing and investor education events, market data and information services, and more.

History of the Dalian Exchange

The Dalian Exchange was established on February 28, 1993. China’s futures industry was revived in 1990 after 60 years, at which point the Dalian Exchange was created. It is a non-profit, self-regulating entity with about 200 members and over 160,000 investors. The exchange has the largest volume of any commodities exchange in China, in part due to the fact that the exchange is an important venue for the circulation of soybeans grown in mainland China. Through the nineties the exchange gained a reputation for financial integrity, risk management and functionality in the market, as well as for transparency and liquidity.

In 2013, the Dalian Commodities Exchange expanded from its role as an agricultural commodities exchange to include industrials, such as iron ore and coke coal. The exchange now has nearly 500,000 participants. In 2015, the DCE was ranked 8th out of the leading global derivatives exchanges by the Futures Industry Association, as well as the largest futures market for oils, plastics, coal, metallurgical coke, and iron ore.

Among its lesser-known traded commodities, the exchange trades: linear low-density polyethene, polypropylene, palm oil futures, eggs, fiberboard, soybeans, soybean meal, soybean oil, genetically modified soybeans, soybean meal options futures, rice, and corn. In 2016, the Futures Industry Association (FIA) reported that the Dalian Commodities Exchange was the 8th largest exchange in the world by trading volume. It boasted half the domestic market share in 2007, and captures roughly 2 percent of the global futures market share, including financial futures.

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Term: Risk-Free Asset

What Is a Risk-Free Asset?

A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the “full faith and credit” of the U.S. government backs them. Because they are so safe, the return on risk-free assets is very close to the current interest rate.

Many academics say that, when it comes to investing, nothing can be 100% guaranteed—and so there’s no such thing as a risk-free asset. Technically, this may be correct: All financial assets carry some degree of danger—the risk they will drop in value or become worthless altogether. However, the level of risk is so small that, for the average investor, it is appropriate to consider U.S. Treasurys or any government debt issued by a from stable Western nation to be risk-free.

KEY TAKEAWAYS

  • A risk-free asset is one that has a certain future return—and virtually no possibility they will drop in value or become worthless altogether.
  • Risk-free assets tend to have low rates of return, since their safety means investors don’t need to be compensated for taking a chance.
  • Risk-free assets are guaranteed against nominal loss, but not against a loss in purchasing power.
  • Over the long-term, risk-free assets may also be subject to reinvestment risk.

Understanding a Risk-Free Asset

When an investor takes on an investment, there is an anticipated return rate expected depending on the duration the asset is held. The risk is demonstrated by the fact that the actual return and the anticipated return may be very different. Since market fluctuations can be hard to predict, the unknown aspect of the future return is considered to be the risk. Generally, an increased level of risk indicates a higher chance of large fluctuations, which can translate to significant gains or losses depending on the ultimate outcome.

Risk-free investments are considered to be reasonably certain to gain at the level predicted. Since this gain is essentially known, the rate of return is often much lower to reflect the lower amount of risk. The expected return and actual return are likely to be about the same.

While the return on a risk-free asset is known, this does not guarantee a profit in regards to purchasing power. Depending on the length of time until maturity, inflation can cause the asset to lose purchasing power even if the dollar value has risen as predicted.

Risk-Free Assets and Returns

Risk-free return is the theoretical return attributed to an investment that provides a guaranteed return with zero risk. The risk-free rate represents the interest on an investor’s money that would be expected from a risk-free asset when invested over a specified period of time. For example, investors commonly use the interest rate on a three-month U.S. T-bill as a proxy for the short-term risk-free rate.

The risk-free return is the rate against which other returns are measured. Investors that purchase a security with some measure of risk higher than that of a risk-free asset (like a U.S. Treasury bill) will naturally demand a higher level of return, because of the greater chance they’re taking. The difference between the return earned and the risk-free return represents the risk premium on the security. In other words, the return on a risk-free asset is added to a risk premium to measure the total expected return on an investment.

Reinvestment Risk

While they’re not risky in the sense of being likely to default, even risk-free assets can have an Achilles’ heel. And that’s known as reinvestment risk.

For a long-term investment to continue to be risk-free, any reinvestment necessary must also be risk-free. And often, the exact rate of return may not be predictable from the beginning for the entire duration of the investment.

For example, say a person invests in six-month Treasury bills twice a year, replacing one batch as it matures with another one. The risk of achieving each specified returned rate for the six months covering a particular Treasury bill’s growth is essentially nil. However, interest rates may change between each instance of reinvestment. So the rate of return on the second Treasury bill that was purchased as part of the six-month reinvestment process may not be equal to the rate on the first Treasury bill purchased; the third bill may not equal the second’s, and so on. In that regard, there is some risk over the long term. Each individual T-bill’s return is guaranteed, but the rate of return over a decade (or however long the investor pursues this strategy) is not.

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Term: Lifeline Account

What is a Lifeline Account?

A streamlined checking or savings account designed for low-income customers often is referred to as “lifeline accounts.”  These accounts will usually have low balance requirements and no monthly fees, and are offered by large banking institutions as a way to offer basic banking services to the broad public. Some states mandate that lifeline accounts be available within the state.

Basic features such as check writing will usually be available, but will typically be limited by a monthly quota. Other electronic services may also be limited unless the account holder pays additional fees.

Understanding Lifeline Accounts

A basic or lifeline bank account goal is to bring all members of a society into the economy by encouraging saving and long-term investing. Low-income citizens are often ignored in the economy because they don’t have a lot of disposable income, but by fostering their long-term financial health, they can become bigger contributors down the road.

Types of Lifeline Accounts

Lifeline accounts are not always called lifeline accounts but sometimes referred to as a basic checking or saving account. The idea behind any of these types of accounts is to bring in first-time customers or low-income customers. These types of accounts do not nickel and dime the account holder in fees.

Example of Lifeline Account

For example, Bank of America offers what it calls a SafeBalance Banking account. This account has no overdraft fees, provides a debit card instead of checks, and offers a predictable monthly maintenance fee, according to the Bank of America website.

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Term: Wildcat Banking

What Is Wildcat Banking?

Wildcat banking refers to the banking industry in parts of the United States from 1837 to 1865, when banks were established in remote and inaccessible locations. During this period, banks were chartered by state law without any federal oversight. Less stringent regulations on the banking industry at the time led to this period, also being referred to as the Free Banking Era.

KEY TAKEAWAYS

  • Wildcat banking refers to the banking industry in parts of the United States from 1837 to 1865, when banks were established in remote and inaccessible locations.
  • Wildcat banks were not fully free of regulation; they were only free of federal regulation. Wildcat banks were chartered under applicable state laws and regulated on the state level. Banking regulations, therefore, varied from one state to the next during the Free Banking Era.
  • The term “wildcat banking” supposedly had its genesis in the 1830s in Michigan, where bankers were believed to have set up banks in areas so remote that wildcats roamed there. Others say the term originated with an early bank that issued currency bearing an image of a wildcat.

Understanding Wildcat Banking

Wildcat banks were not fully free of regulation; they were only free of federal regulation. Wildcat banks were chartered under applicable state laws and regulated on the state level. Banking regulations, therefore, varied from one state to the next during the Free Banking Era. The Free Banking Era came to an end with the passage of the National Bank Act of 1863, which implemented federal regulations governing banks, established the United States National Banking System, and encouraged the development of a national currency backed by the holdings of the U.S. Treasury and issued by the Office of the Comptroller of the Currency.

Origins of the Term ‘Wildcat Banking’

The term “wildcat banking” supposedly had its genesis in the 1830s in Michigan, where bankers were believed to have set up banks in areas so remote that wildcats roamed there. Others say the term originated with an early bank that issued currency bearing an image of a wildcat.

As early as 1812, wildcat was used to refer to an impetuous or foolhardy speculator. By 1838, the term was applied to any business venture considered unsound or perilous. The term “wildcat” then, when applied to a bank, came to mean an unstable bank at risk of failure, and it’s for this reason that wildcat banks have been portrayed as such in Westerns. For example, some Westerns portray wildcat bankers as leaving their vaults open for depositors to see barrels of cash therein. However, the barrels are actually full of nails, flour, or other similarly worthless items, with a layer of cash on top to fool depositors.

Currency Issued by Wildcat Banks

Regardless of the origins of the term, wildcat banks issued their own currency until the National Bank Act of 1863 forbade this practice. These bank locations were sometimes the only places where the bank’s notes could be redeemed, thereby creating a formidable obstacle for their redemption by note-holders and providing an unfair advantage to unscrupulous bankers.

Traditionally, the currency issued by wildcat bankers has been viewed as worthless, and the securities used to back wildcat currencies have historically been questionable. While some wildcat banks used specie to back their issued currencies, others used bonds or mortgages. Different currencies issued by different banks traded at different discounts as compared to their face values. Published lists were used to distinguish legitimate bills from forgeries, and to help bankers and currency traders appraise wildcat currencies.

Before the Federal Reserve System was established in 1913, banks issued notes to extend loans to their customers. An individual could take his or her own banknotes or bills of exchange to the issuing bank and trade them in for a discount of the cash value. Borrowers would obtain bank notes backed by government bonds or species. Such a note gave its holder a claim on assets held by the bank, which, during the Free Banking Era, were required to be backed by state bonds in many states.

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Term: Firm Quote

What is a Firm Quote?

A firm quote is a bid to buy or offer to sell a security or currency at the firm bid and ask prices, that is not subject to cancellation. In simple terms, it’s the level that the market maker will provide liquidity to a counter party.

KEY TAKEAWAYS

  • Broker-dealers and market makers have special functions in the securities markets because they handle orders for customers, as well as trading for their own accounts. That is why they have to comply with specific SEC rules regarding the publishing of quotes and handling customer orders, under the Securities Exchange Act of 1934.
  • Failure by a market maker to honor the quoted bid and ask prices for a minimum quantity is a serious violation of industry regulations, known as backing away. NASD Regulation Inc, which carries out the regulatory functions of the National Association of Securities Dealers and oversees markets operated by NASDAQ, uses an automated surveillance system to enable resolution of backing-away complaints in real time.

Even on Wall Street trading desks there are firm quotes. A customer may call the desk and ask for a live market on a block of stock, options, or ETFs. The trader will go through a quick checklist before providing the quote. Once the firm quote is made, the customer has the opportunity to transact at the stated price or do nothing. Generally speaking, when a block is being priced up by a market making desk, the price quoted is determined by a culmination of many factors including: asset liquidity, event risks, positioning, and market news among other things.

How a Firm Quote Works

Broker-dealers and market makers have special functions in the securities markets because they handle orders for customers, as well as trading for their own accounts. That is why they have to comply with specific SEC rules regarding the publishing of quotes and handling customer orders, under the Securities Exchange Act of 1934.

A firm quote is non-negotiable, according to SEC Rule 11Ac1-1 — its firm quote rule. It is a take it or leave it offer. The market maker who published it is obliged to execute an order that is presented to it, at a price and size that is at least equal to its published firm quote.

Failure by a market maker to honor the quoted bid and ask prices for a minimum quantity is a serious violation of industry regulations, known as backing away. NASD Regulation Inc, which carries out the regulatory functions of the National Association of Securities Dealers and oversees markets operated by NASDAQ, uses an automated surveillance system to enable resolution of backing-away complaints in real time.

Example of a Firm Quote

For example, if a market maker posts a firm bid of $25 for 10K, this tells other dealers or traders that the market maker will buy 10,000 shares for a price of $25. Firm quotes differ from nominal quotes, where the price and quantity of a bid or ask quote are still negotiable.

Another example would be if a buy side firm calls a Wall Street trading desk to price up a block of 1,000,000 shares of an ETF. Let’s assume the ETF is priced at 83.48 x 83.52 on the screens. Additionally, sometimes the customer will not reveal their direction on the trade, thus not allowing the market maker that information. After the bank (market maker) goes through their checklist, they make a quote of 83.45 x 83.53 – each side for 1,000,000 shares. Because the customer is in fact a buyer, they decide to lift the market maker’s offer at 83.53 for the million shares.

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Term: Deck

What is a Deck?

A deck, also known as broker’s deck, is the number of open orders that a broker is working with at any one time. A broker with a large deck must efficiently find buyers and sellers for securities, or she risks the cancellation of orders. More experienced brokers can operate with larger open positions if they are certain in their ability to find counter-parties.

KEY TAKEAWAYS

  • A floor trader works with orders, referred to collectively as a deck, received from clients requesting certain securities be bought or sold. While they work for one of the various stock exchanges, such as the New York Stock Exchange (NYSE), floor traders work only on the accounts they have secured for themselves.
  • A larger deck means that the broker is managing a higher number of orders. This higher level of demand may make it difficult to secure the best deals for every open order available to the broker and may make tracking transactions less efficient.

How a Deck Works

A floor trader works with orders, referred to collectively as a deck, received from clients requesting certain securities be bought or sold. While they work for one of the various stock exchanges, such as the New York Stock Exchange (NYSE), floor traders work only on the accounts they have secured for themselves.

Brokers with a large deck may find holding too many orders to be inefficient or challenging. As a floor trader (FT), the broker works to fill both buy and sell orders as they are received. This requires a high level of interaction with various parties that are interested in making the trade as well as significant research dedicated to each order that is currently held in the deck.

A larger deck means that the broker is managing a higher number of orders. This higher level of demand may make it difficult to secure the best deals for every open order available to the broker and may make tracking transactions less efficient.

Example of Orders in a Broker’s Deck

For example, if a floor trader has an open order for Company A and Company B, it may not be possible to look at fulfillment options for both requests simultaneously. Instead, the trader may have to switch back and forth between the requests or focus on one until completion and then move to the next. While working on the order for Company A, a favorable opportunity may open for Company B. Depending on where the trader is with the Company A order, he may not be able to capitalize on the opportunity for the Company B order.

Another example would be if the broker has a buy order in company A with a limit of 82.50 for a customer and a sell order for company A hits the broker’s deck with a limit of 82.48, the broker will cross the orders mid-market at 82.50 when the quote is inline. By crossing an order, transaction costs are lower for the broker relative to working the orders on the screen (exchange).

Exchange Shutdowns

Based on the availability of certain securities on multiple exchanges and the growing dependency on technology in the trading arena, a broker with a large deck may experience more missed opportunities in the event a technical issue shuts down an exchange.

For example, on July 8, 2015, the NYSE halted operations for approximately three hours. During that time, other exchanges, such as the Nasdaq, continued to trade NYSE-listed stocks as the technical issues did not limit the function of other exchanges. This could cause significant price fluctuations that could affect a trader’s ability to complete an order once service was restored.

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Term: Deep Discount Broker

What is a Deep Discount Broker?

A deep discount broker is an agent who mediates trades on exchanges between securities buyers and sellers at even lower commission rates than those offered by a regular discount broker. As one might expect, deep discount brokers also provide fewer services to clients than standard brokers; such brokers typically provide little more than the fulfillment of stock and option trades, charging a flat fee for each.

KEY TAKEAWAYS

  • Deep discount brokers also provide fewer services to clients than standard brokers; such brokers typically provide little more than the fulfillment of stock and option trades, charging a flat fee for each.
  • With the advent of online trading, deep discount brokers have grown in popularity. Deep discount brokers may even offer other services besides equity trading, such as the ability to write checks on the account, execute trades over the phone, or the availability of research information about stocks, bonds, and mutual funds.

Understanding a Deep Discount Broker

Full-service brokers are licensed financial broker-dealer firms that provide a large variety of services to its clients — including research and advice, retirement planning, tax tips, and much more. All brokers will execute trades for their clients, but a full-service broker will also research various investments and give advice.

The ideal client for a full-service broker is a person with a large investment portfolio but lacks the time or desire to manage his or her own investments. In return for these services, full-service brokers typically charge high fees when a client buys or sells stocks. For example, a client may pay $150 or even $200 per trade with a full-service broker, while the same trade would cost between $5 and $10 online with a deep discount broker. Full-service brokers also charge annual service charges or maintenance fees on their clients’ accounts.

With the advent of online trading, deep discount brokers have grown in popularity. Deep discount brokers may even offer other services besides equity trading, such as the ability to write checks on the account, execute trades over the phone, or the availability of research information about stocks, bonds, and mutual funds. These days when it comes to trade execution, discount brokerages often use the same third-party services as brand ones. For example, TD Ameritrade uses third party execution services such as Knight, Citadel, and Citigroup — the same third-party services are used by TradeKing, (purchased by Ally Invest), but for about half the price.

Most brokers offer flat-fee stock trading. However, some brokers, especially active trading-focused brokers, offer per-share trading. Both have their pros and cons; it depends on an investor’s average trade order size. For example, placing 2,000 share orders, on average, would make a per-share broker expensive, compared to a flat-fee broker. The vast majority of investors, over 99%, trade with a flat-fee broker. Brokerages may also require a minimum balance of anywhere from $500 to $2,000. However, the brokerages may waive the minimum requirement for investors who are opening an IRA.

Over the last few years, commission free trading has been all of the rage. The reason a deep discount broker can afford to do this is because they sell the order flow to HFT firms and hedge funds. The latest firms to offer commission free trading on stocks, ETFs, and options are: Fidelity, Etrade, & Schwab.

Example of a Deep Discount Broker Trade

For example, Charles is looking to open a brokerage account and is deciding between a full service broker and a deep discount broker. He has learned that the full-service broker offers tax advice and planning, as well as consultations. The deep discount broker only offers execution of orders at the low price of $1 per trade vs. $35 per trade at the full-service broker. Because he is only interested in execution and no other services, he decides to do his business with the deep discount broker.

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Term: Blocked Period

What is a Blocked Period?

A blocked period refers to a length of time in which an investor’s securities are prevented from being accessed. A blocked period may be put in place if an investor has used a security as collateral, as it prevents the investor from using the same security as collateral or from selling the security. It may also refer to a period of time in which an investor cannot access account funds.

  • Blocked periods denote periods of time where an investor cannot access their assets. Brokerages and financial institutions may place a hold on the securities in an investor’s account for several reasons.
  • Brokerages may be required to block an account for a period if the account holder buys or shares securities without having sufficient capital to complete the trade, referred to as freeriding. The specific regulation governing this is called Regulation T and specifically relates to cash accounts.
  • For novice traders, familiarizing oneself with these rules beforehand will make life a lot easier because a blocked period can come as a surprise to those unaware of the rules/laws. A lot of these rules are in place to protect both the investor and the broker dealer.

How a Blocked Period Works

Blocked periods denote periods of time where an investor cannot access their assets. Brokerages and financial institutions may place a hold on the securities in an investor’s account for several reasons. Reasons include the investor being labeled a day trader using a margin account, or the investor using a security as collateral in a trade.

Investors who trade frequently may be considered to be day traders by the Securities and Exchange Commission (SEC). This label may bring with it requirements for how much money must be available in the investor’s account at a particular point in time. A pattern day trader label is given if an investor buys or sells stocks using a margin account more than a defined number of times during a week.

Brokerages may be required to block an account for a period if the account holder buys or shares securities without having sufficient capital to complete the trade, referred to as freeriding. The specific regulation governing this is called Regulation T and specifically relates to cash accounts.

For novice traders, familiarizing oneself with these rules beforehand will make life a lot easier because a blocked period can come as a surprise to those unaware of the rules/laws. A lot of these rules are in place to protect both the investor and the broker dealer.

An Example of a Blocked Period

If an investor with a cash account tries to purchase shares with funds that have not yet been settled from a previous trade, the brokerage firm’s compliance and trade monitoring department may issue a blocked period. The blocked period lasts ninety days. During this time, the investor may make purchases, but only with completely settled funds. Investors can avoid this type of blocked period by trading on margin, though margin accounts are subject to other rules regarding minimum balances.

Let’s say this investor has $5000 in her cash account and she decides to buy 100 shares of ABC at a price of $50 per share. She transacts the trade and a month later she decides to sell the shares for $52 per share. If she tries to purchase another stock with those funds on the same day as the sale, she will be blocked because the funds have not had the chance to settle. Generally speaking, U.S. equities clear T + 2. So, if the sell of ABC happened on a Monday, the investor would not be able to buy another security with those funds until the settlement date of Wednesday at the earliest.

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Term: Co-Owner

What Is a Co-Owner?

A co-owner is an individual or group that shares ownership in an asset with another individual or group. Each co-owner owns a percentage of the asset, although the amount may vary according to the ownership agreement. The rights of each owner are typically defined in accordance with a contract or written agreement, which often includes the treatment of revenue and tax obligations.

KEY TAKEAWAYS

  • Co-owners can be a group or individuals that own a percentage of an asset in conjunction with another individual or group.
  • The revenue, tax, legal, and financial obligations can be different for each co-owner.
  • There are risks to co-ownership, which can include shared responsibility for the other party’s reckless or negligent actions.

Understanding Co-Ownership

The relationship between co-owners can vary, and the financial and legal obligations depend on the benefits each party ultimately wishes to receive. For real estate, the legal concept of co-owner, in which the parties involved may operate under joint tenancy or tenancy in common, has important ramifications.

Similarly, co-owners of a brokerage account or bank account are bound by strict procedures and legal constraints concerning account activity and the benefits obtained from the account during the time when the account is active. When the account is closed, co-owners or legal representatives of the co-owners must be involved.

Co-owners are bound to different legal constraints depending on the ownership structure. In real estate, for example, co-owners could operate as joint tenants or tenants in common.

Partners vs. Co-Owners

Partnership and co-ownership are two different things. For example, if two brothers purchase a property, that is co-ownership. Both brothers must agree if the property is to be sold, and the two would share the proceeds from the sale. However, the original purchase of the house was not necessarily intended as a profit-making transaction.

However, if the property was bought with the intention of earning rental income, then this would be a partnership because there is both joint ownership and a business motive for the investment.

Additionally, partners can act in the interests of the business or as agents of the business. With co-ownership, there is no such agency relationship. Each co-owner is only responsible for their own actions, and they do not have to act in the interests of the owned asset.

Problems With Co-Owners

Sharing ownership of an asset has risks. For example, co-owners of a firm may not agree on how to run the business. Buying out a co-owner can be very difficult if they are not willing to sell their share.

Real World Example

For example, consider a situation where a co-owner of a bank account irresponsibly gambles away a large sum of money on casino credit. The casino, as the creditor, could come after the account, leaving the responsible party exposed to a significant loss. Careful titling of accounts is particularly important in estate planning. If someone chooses to name a co-owner to an account and is not strategic about who is named, they run an enormous risk that the assets will not be distributed as desired upon passing.

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Term: Clash Reinsurance

What Is Clash Reinsurance?

Clash reinsurance is a type of extended reinsurance coverage which protects a primary insurer from excessive loss claims on a single event. There can be several scenarios in which clashes may result in excessive claims after a single coverable event. Clash reinsurance may apply to natural disasters or financial and corporate disasters.

Primary insurance companies purchase clash reinsurance for their security. Ceded reinsurers may also only take a proportional amount of the clash coverage risk, requiring a primary insurer to deal with several ceded reinsurers in order to get the coverage they desire. Clash reinsurance coverage reduces the maximum potential payout for an insurer if a single event leads to claims in excess of a specified level.

KEY TAKEAWAYS

  • Clash reinsurance is a type of reinsurance coverage protecting an insurer from excessive claims on a single event.
  • There can be several scenarios in which clashes may result in excessive claims after a single coverable event.
  • Clash reinsurance is commonly utilized for mitigating excessive payouts from the occurrences of natural disasters, financial disaster, and corporate disasters.

Clash Reinsurance Explained

Reinsurance is a corporate business involving companies who reinsure insurers in order to limit or diversify some of the risks that arise from insurance policy claims. There can be a few different scenarios in which clash reinsurance may be applied. Comprehensively, clash reinsurance involves a great deal of documentation as well as liability management in order to execute appropriately.

Clash reinsurance builds on the basic premises of reinsurance, which allow a primary insurer to set limits for their own obligations. Reinsurers step in to insure a primary insurer after a specific threshold has been met.

Clash Scenarios

There can be two distinctly different types of clash reinsurance scenarios. Commonly clash reinsurance will involve multiple claims of the same kind from a single event. However, clash reinsurance can also be sought when a primary insurer agrees to insure a client from multiple angles associated with a single event.

An insurance company may seek out clash coverage from a reinsurer if one single coverable event could result in two or more claims to the primary insurer from multiple insured policyholders. For example, a primary insurer may use clash reinsurance when approving multiple property and casualty policies for multiple policyholders against hurricane damage in a geographic area where hurricanes are very likely.

Other catastrophic events where multiple claims might occur for an insurer from multiple policyholders could also include flooding, fire, or earthquake coverage. If a geographic area is at a high risk of any particular natural disaster under coverage, and the insurer approves multiple policyholders in that area, then clash reinsurance to help cover claims over a specified threshold could be a good risk management strategy.

Beyond just multiple claims from multiple policy holders, clash reinsurance may also involve scenarios in which a single policyholder can make multiple claims on a single event which may lead to an excessively high payout from a primary insurer. Situations like this might involve coverage for executive directors when both director and officer compensation clauses as well as errors and emissions compensation clauses are both in force. If a single individual can reap the benefits of multiple claims from a single event and this is in effect for multiple parties under an insured umbrella then the risks are very high for a primary insurer and thus the need for clash reinsurance also becomes higher.

Mitigation of Risk through Clash Reinsurance

Reinsurance is insurance for insurers or stop-loss insurance for these providers. Through this process, a company may spread the risk of underwriting policies by assigning claim payouts to other insurance companies. The primary company, who originally wrote the policy, is the ceding company. A second company, who assumes the risk, is a ceding reinsurer. In some cases, there may be multiple ceding reinsurers. The reinsurer(s) receives a prorated share of the premiums. Reinsurers will usually take on losses above a specified threshold. However, reinsurance contracts may also be structured so that the reinsurer takes on a designated percentage of claim losses.

Overall, the use of reinsurance, and clash reinsurance specifically, is a part of a risk management strategy. Primary insurers can more accurately target maximum liabilities while also reaping the greatest profits from policy premiums when they use clash reinsurance. With clash reinsurance, the insurer pays a small premium to a reinsurance company for the assurance that liabilities will not exceed a target level and become impossible to repay at all or repay with any profits. These efforts help to prevent unbearable losses or even bankruptcy, specifically when massive calamity occurs.

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