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.
- Higher Probability of Loss in Securitization: Reinsurance companies are experts when it comes to analyzing risks. They are very aware of what their current risk portfolio is and how the addition of a particular risk will impact their current portfolio. As a result, reinsurance companies are able to better understand which risks they can bear and which they cannot.
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.
- Securitization is Expensive: It is true that when an insurance company issues securities, it is spared the expense and hassle associated with reinsurance. However, securitization is an expensive affair.
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.
- Lack of a Liquid Secondary Market: The success of any securitization is ultimately dependent upon the availability of a thriving secondary market. This is because, in the absence of a thriving secondary market, the initial investors will be forced to hold on to their investments till maturity. There are very few investors who want to make illiquid investments that they cannot utilize in case of an emergency. There is a secondary market but it only exists in some developed countries. Hence, securitization is witnessing a lack of investor interest in most parts of the world and this can be traced back to the absence of a secondary market.
- Risk of Litigation: Reinsurance contracts have been used in the open market for many years. As a result, reinsurance contracts have become more or less standardized. Also, the laws relating to insurance and reinsurance are well-developed in most parts of the world. Contrary to this, the agreement that is made between the insurance company and the investors in the event of securitization is not that well developed. This means that either party can make changes to the contract or insert some clauses which may be considered to be vague. As a result, there is a larger chance of litigation related to securitization as compared to reinsurance.
- Lack of Continuity: When an insurance company takes a reinsurance contract, it is assured of continuity. The contract between the insurance company and the reinsurance company is renewed periodically after making minor adjustments to the premium. Unless the reinsurance company goes out of business (which does not happen very often), the ceding insurer can be certain about the continuity of the reinsurance contract.
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.
- Size of the Risk: It is also important to note that reinsurance companies are capable of taking on very large catastrophe risks from the ceding insurer. However, the same cannot be said about the investors in the securities market. The securitization of insurable risks is still relatively new. As a result, very large ticket securitizations have not taken place till now. Both the ceding insurer as well as the investors are skeptical when it comes to making large ticket securitizations and prefer to continue using the traditional reinsurance route.
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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