MSG Team's other articles

10662 The Political System and Civil Liberties: Theory and Practice

The Concept of Civil Liberties and Human Rights An important topic in political science concerns the provision of civil liberties and the practice of human rights in modern nation states. It goes without saying that in dictatorships, civil liberties are curtailed, and human rights are nonexistent. Hence, our focus in this article is on the […]

9875 Importance of Leadership

Leadership is an important function of management which helps to maximize efficiency and to achieve organizational goals. The following points justify the importance of leadership in a concern. Initiates action- Leader is a person who starts the work by communicating the policies and plans to the subordinates from where the work actually starts. Motivation- A […]

9087 Why Effective Governance is the Only Way to Sustained Economic Growth

Effective Governance is a key reason why Nations Grow or Fail Nations and societies grow for a variety of reasons and strong and stable institutions are one of the them. When countries have a well functioning bureaucracy, competent law enforcement agencies, and a capable judiciary, it follows from this that the country would grow economically. […]

12863 Managing Conflict in Interpersonal Relationship at Workplace

When two individuals have different opinions and neither of the two is willing to compromise, conflict arises. A state of disagreement among individuals is called as conflict. Conflict arises at workplace when employees find it difficult to reach to mutually acceptable solutions and fight over petty issues. Differences in attitude, mindsets and perceptions give rise […]

11249 Setbacks of Organization Culture

What is Organization ? A common platform where individuals from different backgrounds, mentalities, educational qualifications, interests and attitudes come together to work towards a goal as well as earn bread and butter for themselves is called an organization. Every organization has a unique style of working often called its culture. Culture – The ideologies, beliefs […]

Search with tags

  • No tags available.

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.

  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Cyber Risk in Reinsurance

MSG Team

Combining Towers While Building a Reinsurance Portfolio

MSG Team

Climate Change and Reinsurance

MSG Team