It is common for insurance companies to not hold the entire risk that they underwrite on their own portfolios. Instead, insurance companies try to find ways and means to offload some of this risk to other entities. This is common with all types of insurance. However, it becomes more pronounced with catastrophe-related insurance. This is because of the fact that catastrophe insurance is generally related to huge losses which can cause significant damage to the balance sheet of the insurance company.

Reinsurance is one of the most obvious ways in which organizations offload some of their risks to other entities. However, it is not the only way.

Securitization of insurance risks has also been used by insurance companies in the past. In this article, we will understand what is the securitization of insurance risks and how it can be used as an alternative to reinsurance.

How Does Securitization Work?

Securitization works in a manner that is very similar to traditional reinsurance. However, the advantage is that regular investors can purchase catastrophe bonds. There is no requirement for having a license to issue a reinsurance policy in order to underwrite this risk.

If an insurance company wants to use securitization to transfer risks worth $1 million, then they will simply issue $1 million worth of cat bonds. This means that they collect $1 million from the investors. Now, if the catastrophe does occur, then the $1 million principal payment will be forfeited and only the coupon payment will be made to the investors. The forfeited principle will be used to make good for the loss of the insurance company in the event of a catastrophe.

However, if the catastrophe does not occur, then the payment of the principal as well as the agreed-upon coupon rate will be legally binding on the issuing insurance company. Hence, in effect, the insurance company is obtaining a reinsurance cover from multiple small investors in the open market instead of approaching a single insurance company.

Why is Securitization so Popular?

The recent past has seen a rapid increase in the popularity of securitization as an alternative mechanism to obtaining reinsurance. This is because of the fact that securitization has several advantages. Some of the main factors responsible for this increase in the quantum of securitization have been mentioned below:

1. Capacity can be Created Instantly: It is important to note that the capacity for offering reinsurance services is limited in the reinsurance market. Unless another reinsurance company comes into existence by obtaining a license, this capacity cannot be expanded easily. It is also difficult for the existing companies to obtain more capital at a short notice so that they can increase or decrease their ability to provide reinsurance at a short notice. This is not the case with securitization.

   Securitization does not have to be done by a reinsurance company. The insurance company can approach investors on the open market in order to offload some of their risks. This helps in the creation of additional reinsurance capacity when required and this capacity can be extinguished when it is not required.

2. Fewer Regulatory Hurdles: As mentioned above, the process of securitization does not require the involvement of a licensed reinsurance company. Instead, the insurance company is issuing bonds which it then sells on the open market.

   Although, the regulations regarding the issuance of bonds differ from country to country, in most parts of the world these regulations are considered to be quite lenient when compared with the regulations for insurance and reinsurance companies. This means that insurance companies have to face fewer costs and hassles related to regulatory issues when they issue securities as compared to when they opt for a reinsurance cover.

3. Availability of More Risk Capital: It is important to note that the amount of capital that is used for reinsurance is limited to the amount of capital which is held by reinsurance companies. However, this is not the case when it comes to securitization.

   Securities can be purchased by eligible investors all over the world. Hence, the pool of capital which can be used to support a viable securitization issue is much higher as compared to the pool which is used for reinsurance. The availability of more risk capital makes it cheaper for insurance companies to issue securities in most cases.

4. Better Cash Flow Arrangements: Last but not the least, the cash flow arrangements related to securitization are more favorable for the issuing insurance company. When the insurance company issues the bonds, it collects cash immediately and can earn interest on this money.

   Also, the premium related to risk management is paid out in the form of a coupon payment. This generally means that the payment is made at the end of the tenure. Hence, the insurance company has a delayed cash flow schedule and can use the cash to manage its other liabilities in the meanwhile.

   If managed efficiently, this cash flow timing advantage can be significant and can translate into cost benefits for the insurance company.

The bottom line is that securitization is a viable alternative to reinsurance in some cases. However, more information needs to be collected and analyzed before making any decision.