In the previous article, we have already seen how reinsurance pools work. We have also seen how the governments of countries around the world collaborate with private reinsurance companies in order to make the concept of reinsurance pools a success. However, a deeper knowledge of this subject is required by any student. Hence, in this article, we will have a closer look at the pros and cons of this arrangement.
Pros of Reinsurance Pools
The popularity of reinsurance pools is the result of the many advantages that this arrangement has to offer. The details related to the advantages are as follows:
- Helps Improve Affordability: The first and foremost benefit of reinsurance pools is that it helps reduce the premium charges and hence make the product more affordable. This happens because the reinsurer is not able to transfer their risk further. Hence, they try to create a big pool of money if they expect a catastrophe to happen. This is done to avoid insolvency.
Increasing premiums make reinsurance less affordable which ultimately trickles down and makes insurance less affordable in itself. When reinsurance companies have their cash flows secured by the government, they are able to offer reinsurance at an affordable price.
- Increases Market Coverage: Affordable reinsurance facilitates affordable insurance. As a result, a large number of people are able to purchase policies. This solves the problem of underinsurance and creates a wider insurance net. This increased proliferation of disaster insurance is one of the main reasons why governments support reinsurance pools.
- Increases Trust in The System: Since reinsurance pools are guaranteed by sovereign entities, there is almost a negligible chance that they will face any kind of financial duress. As a result, the end customers as well as insurance companies have increased faith in the reinsurance system. The increased trust eventually translates to increased revenues and benefits the industry as a whole.
- Encourages More Competition: There are certain geographical locations and even industries that insurance companies consider unviable under normal circumstances. For instance, the Northern coast of Australia was more prone to natural disasters as compared to the rest of the country. It is for this reason that very few insurance companies were operating in that area.
Fewer insurance companies also meant lesser scale for reinsurance companies. As a result, the reinsurance costs were prohibitively high. The entire situation was a vicious circle. With the advent of reinsurance pools, governments were able to encourage more insurance and reinsurance companies to conduct business in that area. Over the years, it has transformed from an underpenetrated insurance market to a vibrant one.
- Cost Neutral in the Long Run: Also, a well-managed reinsurance pool only needs the government to provide a sovereign guarantee. The guarantee is used as a confidence-building measure. However, governments do not have to actually spend any funds.
The funds collected in the form of premiums are usually less than the amount of money that has been paid out in claims in the long run. Hence, empirically, governments have not had to spend taxpayers money. However, it cannot be denied that the money needs to be put at risk.
Cons of Reinsurance Pools
Reinsurance pools have also been the subject of a lot of criticism. This is because of the following reasons.
- Lack of Transparency: Firstly, the reinsurance pool structure is quite opaque. The government does not have the time or the capabilities required to monitor and manage a catastrophe insurance fund. Hence, in most cases, even though government regulators keep an eye on the reinsurance companies, the operation is not completely transparent.
This lack of transparency can mean increased risk for the governments as well. However, in real life reinsurance companies ensure that they do not take an excessive risk since their partnership with the government is quite valuable to them.
- Can Add to Sovereign Debt: Theoretically, reinsurance pools have been cost neutral. In most parts of the world, governments have not had to contribute financially to cost pools. However, in the event of an extremely adverse event taking place, it is quite possible that the government may have to pitch in to pay out the claims. In such cases, reinsurance pools can end up adding to sovereign debt and creating pressure on the taxpayers funds.
- Need Political Commitment: Since reinsurance pools are an arrangement between government and private companies, it is possible that the finances can be mismanaged.
For instance, it is possible that the government may take on excessive risks in order to please the residents of a particular area because elections may be around the corner. In such cases, these reinsurance pools can become the reason for financial duress. Reinsurance pools require political commitment from the political class. They must refrain from misusing this policy in order to achieve short-term electoral gains.
- Adverse Selection: Last but not the least, there is a huge information asymmetry between the government and the reinsurance companies. Hence, it is quite likely that the government may not be well equipped with the information it needs to make decisions that are in its own financial interests.
The bottom line is that reinsurance pools have their own pros and cons. However, it needs to be understood that at the moment, the pros outweigh the cons and as a result, the popularity of this mechanism is increasing. It is likely that this streak will continue for a few more years.
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