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Underlying Security

Updated on October 4, 2023

The term “underlying security” refers to the financial asset or instrument that serves as the basis for certain types of insurance policies, particularly those related to financial protection and risk management. Underlying securities are typically associated with insurance products like financial guarantees, surety bonds, and some investment-linked insurance policies. These securities provide financial backing or collateral to fulfil the obligations outlined in the insurance contract.

What are the types of Underlying security in Insurance?

Financial Guarantees – In specific insurance policies, often used for loans or investments, an underlying security, which can be cash, a letter of credit, or other financial instruments, is required to protect against defaults or non-payment.

Surety Bonds – Surety insurance involves principals, typically businesses or contractors, providing an underlying security, such as a financial asset or collateral, to a surety company to ensure they fulfill their performance obligations, with the surety company able to use this collateral to compensate the obligee in case of non-compliance.

Investment-Linked Insurance – In certain investment-linked insurance policies, the underlying security comprises a portfolio of investments like stocks, bonds, or mutual funds, and the performance of these investments directly impacts the policy’s cash value and potential payouts.

What are the functions of Underlying Securities?

Risk Mitigation – Underlying securities are vital for mitigating risks in insurance contracts by serving as a financial buffer or collateral to cover potential losses, ensuring the insurer’s ability to fulfil its commitments.

Performance Link – In investment-linked insurance policies, the performance of underlying securities has a direct influence on the policy’s financial outcomes, allowing policyholders to potentially gain from investment returns while bearing exposure to market risks.