Cyber Risk in Reinsurance
February 12, 2025
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In the previous article, we have already studied about the concept of reinsurance sidecars. We now know what reinsurance sidecars are and how they are structured. We know why insurance sidecars have revolutionized the reinsurance industry. However, it is equally important to know what are the pros and cons of reinsurance sidecars so that a decision can be taken regarding whether or not a reinsurance company wants to use this structure to raise funds.
The concept of reinsurance sidecars has been gaining significant popularity in the recent past. This is because of the fact that there are some significant advantages which are associated with the idea. An indicative list of some of the advantages are as follows:
The reinsurance sidecar gives them the perfect opportunity to invest in the industry only for a short period of time when the situation is favourable to them. Hence, reinsurance sidecars are a temporary structure which can provide support to the industry when needed and can then be dissolved.
If a hedge fund investor invests directly in the reinsurance company, they have to assume all the risk of the company. However, when it comes to an insurance sidecar arrangement, the investors can literally pick and choose the type as well as the extent of risks which they are comfortable with.
The reinsurance sidecar is a convenient short-term solution for the reinsurance company to raise capital temporarily with minimal hassles.
Now, it needs to be understood that almost every financial innovation has its flipside and the reinsurance sidecar is not really an exception.
A sidecar arrangement allows third party financial entities to inspect the books of the reinsurance company and even have a say in their decision making. This could be problematic for both parties if they do not agree on the risk return profile which needs to be adhered to during the existence of their partnership.
Catastrophe Modelling is a complex activity which reinsurance companies can do quite well. However, hedge funds may not have the core competency required to make the right decisions. It is for this reason that there is a high probability that the hedge fund may end up selecting the wrong reinsurance partner or taking up too much reinsurance risk. The only way for hedge funds to mitigate this risk is to learn more about the business of reinsurance and catastrophe modelling which isn’t really their core skill!
For instance, in summer there is almost zero chance of a snowstorm occurring. Hence, prorating the premium is not only about the number of months. This can lead to tremendous complications particularly when contracts have to be terminated.
The fact of the matter is that reinsurance sidecars have their pros and cons. The cons are somewhat difficult to mitigate even after knowing that they exist. However, the benefits are so significant that most investors are willing to overlook the complications and continue with the arrangement.
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