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In the previous articles, we have already studied what a catastrophe is and how it impacts the reinsurance market.
Catastrophe modeling as well as other techniques have been used to try to predict catastrophes more accurately. However, they still end up causing a lot of economic loss to the reinsurance market.
Over the years, companies have tried different types of financial innovations in order to overcome this problem. A reinsurance pool is one such innovation that has been done. In this article, we will have a closer look at what reinsurance pools are as well as how they play an important part in the reinsurance industry.
Reinsurance pools are a mechanism using which sovereign governments can help private reinsurance companies better manage and underwrite risks. Reinsurance pools are most useful in times of natural catastrophes.
The idea behind the reinsurance pool is that when natural disasters happen, the price of reinsurance goes up. This creates a situation of underinsurance. However, the price of insurance does go up because of the increasing price of reinsurance as well.
In many parts of the world, the sovereign government steps in and enters into a contract with reinsurance companies. As per this contract, the reinsurance claims are backed by a sovereign guarantee up to a certain extent. This means that if a catastrophe does strike, then the government will pay the claims if the reinsurance company runs out of money. Hence, reinsurance pools are a mechanism for governments to support the reinsurance company by sharing the risks.
Most reinsurance pools are designed to be cost-neutral. Even though sovereign governments provide backing to these private reinsurance companies, they actually have no intention of picking up the bill. The real reason that governments back reinsurance companies is to give them confidence.
Reinsurance companies often raise premium rates in order to cover their losses which occur intermittently. Governments provide sovereign guarantees to augment the cash flow when the calamity does hit. However, during the periods when there is no calamity, the reinsurer has to pay the government.
Hence, in effect, there is no additional cost to the government if the reinsurance pools are well managed. However, at the same time, a poorly managed pool can cause a significant loss of cash flow to the government because in the end, the government funds i.e. the taxpayer money is actually at risk in such an arrangement. Hence, it can be said that governments do not enter into this arrangement for purely financial purposes. The main motive of sovereign entities is to increase the coverage of reinsurance.
Over the years, several reinsurance pools have been created. These pools can be bifurcated into many different types. The most common classification of reinsurance pools is as follows:
For instance, it is possible to take insurance only against earthquakes and not other insurance calamities. Also, in such reinsurance contracts, the payments become due almost immediately after the calamity happens. This is because, in such reinsurance contracts, the amount payable is not based on the actual losses. Instead, it is based on the magnitude of the calamity.
For instance, in the case of an earthquake, the pay-out will be based on the magnitude of the earthquake on the Richter scale instead of actual losses suffered.
Reinsurance risk pooling is a concept that is only a couple of decades old. However, in this short span of time, it has become increasingly popular. Right now, several countries in the world have sovereign funds backing reinsurance pools. These include developed countries such as Australia, the United Kingdom as well as the United States.
It also includes poor and developing countries such as African and Latin American nations. The idea has been rapidly growing in most parts of the world. In fact, there are already many offshoots and variations of reinsurance risk pools that are already available in the market. We will have a closer look at those variations in the forthcoming articles in the module.
The fact of the matter is that reinsurance risk pools are a very important concept when it comes to risk management in the reinsurance industry. It is only because of the continuous innovation which has been happening in this field that reinsurance companies can confidently take on more risks and still be able to fulfill their commitment.
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