The insurance industry is a large and diversified industry. It has several different types of products and operates in multiple geographies. This means that the risks on the balance sheet of the insurance company can be quite diversified. This means that a reinsurance company is also exposed to a lot of variety when it comes to products whose risks they assume. It is common for insurance companies to bundle their various risks so that the size of the underlying risk becomes large enough to gather interest from reinsurance companies.
In this article, we will have a closer look at what is bundling insurance exposures while obtaining reinsurance. We will also have a closer look at the two main types of reinsurance bundling which is commonly used by reinsurance companies.
The Need for Bundling
Reinsurance companies are not like regular insurance companies. They do not deal with individual customers. Instead, they deal in bulk. Hence, reinsurance companies are only interested in providing cover and undertaking a risk if there are significant volumes involved. This is often because the transaction costs involved in the process are so large that they make offering small coverage unviable.
Reinsurance companies will typically not offer coverage below a certain dollar amount. Even if they do offer coverage, the cost of coverage tends to reduce exponentially as the dollar amount of the underlying risk increases. Hence, bundling of risk is a common practice amongst insurance companies so that they can make their underlying risk coverage attractive for a reinsurance company.
There are two main ways in which insurance coverage is bundled together in order to create a pool for the reinsurance company. These two ways have been explained below:
What is Homogenous Bundling?
Homogenous bundling refers to the process of making a large insurance pool by combining more of the same risk. For instance, an insurance company can make its motor insurance pool larger by adding more and more underlying coverage related to other motor policies. This is generally done by insurance companies as they aggregate the insurance policies from their different subsidies.
- Suitable for Very Large Insurance Companies: Homogenous bundling is suitable for very large insurance companies. This is because large insurance companies tend to have similar risks in different parts of the globe. Using homogenous bundling, large insurance companies can aggregate all their volume pertaining to similar risks into one insurable interest and then obtain the best deal from the reinsurance company.
- Easy to Track Risks: The advantage of homogenous bundling is that since the risk is similar, the underlying risk factors are also very similar to each other. From a reinsurer’s point of view, this makes it easier to generate risk models which can be used to understand and mitigate the relevant risks. Also, since homogenous bundled portfolios are generally taken from different geographies, there is an element of diversification already built in. It is very unlikely that the same catastrophe will strike at all locations at the same time.
- Lack of Information: The disadvantage of homogenous bundling according to the reinsurers’ point of view is that there can be a significant lack of information related to some underlying covers. For instance, when insurance companies bundle coverages from different geographies, they aggregate covers from places where there is significant data available about insurance products with covers from places where there is no data available. This lack of data in certain developing markets makes it difficult to accurately price the risk being transferred.
What is Heterogenous Bundling?
Heterogenous bundling is another important type of bundling which is used by insurance companies around the world. Heterogenous bundling refers to the mixing of different types of covers.
For instance, an insurance company reinsures its entire portfolio. This could mean that a reinsurance company bundles its risk exposures across home, motor, life, and even corporate insurance and reinsurers the entire bundle on the same policy. Since different types of underlying risks are being bundled in such cases, it is called heterogenous bundling.
- Useful for Small Insurance Companies: It is important to note that heterogenous bundling is generally used by small insurance companies. These insurance companies are not able to generate enough scale on a single line of business. As a result, the companies are compelled to bundle different risks together so that their business becomes large enough for reinsurance companies to consider.
- Higher Premium: It is important to note that heterogenous bundling is considered to be risky by many reinsurance companies. This is because reinsurance companies do not have the tool to accurately price the risk associated with different lines of business. As a result, reinsurance companies charge higher premiums for providing such policies. Smaller insurance companies are willing to pay these higher premiums since it allows them to get reinsurance coverage and frees up some additional capital.
- Diversified Risks: Last but not the least, there is an element of diversification built into the portfolio. Since different types of risks are covered, there is a high chance that some of these risks may be negatively correlated and as a result, the pay off from one risk may be quite different as compared to the other. In the end, the risks average each other out which works in the interest of the reinsurance company.
The fact of the matter is that bundling is a very important strategy that facilitates the reinsurance business. Both homogenous, as well as heterogenous bundling, enable insurance companies to transfer their risks in a more organized manner.
