Cyber Risk in Reinsurance
February 12, 2025
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In the previous article, we have already seen what securitization is in the context of reinsurance. We have also seen how securitization can be used as an alternative to reinsurance and the reasons behind the sudden increase in the volume of insurance-related securitizations around the world.
It is true that catastrophe-related securities have started proliferating different aspects of the financial system in the recent past. However, it is also true that with the increased proliferation of securitization, many of the flaws associated with securitization as a risk management tool have also come to light. In this article, we will have a look at some of the common disadvantages related to using securitization as a tool for managing insurance risks.
The probability of adverse selection is low in reinsurance because advanced statistical models are available. However, when it comes to securitization, the risk is often borne by investors who are not experts in this regard. They are not aware of how the addition of this risk affects their portfolio. Hence, there is a higher probability of investors losing money when it comes to securitization.
In the short run, this is beneficial for the ceding insurance companies. However, in the long run, this often means that fewer investors are willing to purchase securities that act as an alternative to reinsurance.
First and foremost, the ceding insurance company cannot securitize its underlying risks on its own. They need to obtain the services of an investment bank which will underwrite and distribute these securities amongst prospective customers. However, the transaction fees and charges associated with the use of an investment bank can be quite large. As a result, securitization might end up becoming expensive even if we consider the repeated regulatory expenses that occur periodically when the reinsurance route is taken.
However, this is not the case when it comes to securitization. Once a securitized contract has been completed, the entire contract has to be recreated. This generally means more transaction charges. However, it also means that the existing investors may not want to take the same risk again.
The investment banker will have to find new investors every time a new contract is made. Rolling over the existing contract can become quite difficult particularly if a loss has occurred in the previous period and the principal amount is not being refunded to the investors.
From the above points, it is obvious that while securitization is a viable alternative as compared to reinsurance, it is not without its flaws. Hence, it is important for ceding insurance companies to be completely aware of the pros and cons of securitization before they break a long-term relationship in order to make a short-term decision.
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