Reinsurance and Foreign Exchange Risks

All insurance companies face foreign exchange risks to some extent. However, all insurance companies are not equally concerned about foreign risks. This is because, for most insurance companies, the risks as well as the premiums are collected in the same currency. Generally, the business of an insurance company tends to be managed locally. However, this is not the case with reinsurance companies.

Reinsurance companies typically do not create several entities which manage their business on a national level. Instead, the business of foreign exchange companies is managed at an international level. This is the reason why the risk exposure of any reinsurance company is spread across several geographies and is also denominated in several currencies. Thus reinsurance companies face a larger risk related to adverse events from foreign exchange markets as compared to regular insurance companies.

In this article, we will have a closer look at what some of those risks related to foreign exchange are and how they impact the business of a company engaged in the business of reinsurance.

Types of Foreign Exchange Risks Faced by Reinsurance Companies

The first step towards understanding the relationship between reinsurance companies and foreign exchange risks is to understand how the latter impacts the former. Most reinsurance companies claim that foreign exchange risks impact them in two important ways:

1. Accounting Risks: Reinsurance companies have risks priced in different currencies on their balance sheet. However, when they report their financial results, they need to do so in their home country’s currency. Hence, on the day of publishing the results, the reinsurance company has to notionally convert the foreign exchange balance into local currency and post the same in a profit or loss account.

   It needs to be understood that no real transaction takes place. Instead, the profits and losses are completely notional and done for the sole purpose of being able to report accounting profits and losses. As a result, the risk of accounting losses arising from the notional conversion of currencies is quite limited. However, it still continues to be an important area of concern for reinsurance companies.

2. Economic Risks: Economic risks, unlike accounting risks are not notional. Instead, the economic risks arise from the fact that the reinsurance portfolio of any reinsurance company comprises many international risks. These risks arise from the fact that the original risk is generated in different countries and hence losses may have to be paid out in local currencies.

   It is nearly impossible for a reinsurance company to predict the actual pay-outs that will have to be made in relation to different risks which have been undertaken. As a result, it is quite possible that the reinsurance company may face an adverse forex rate scenario.

   It is important to understand that in the event of catastrophe losses, a large number of claims are simultaneously being paid off in the local currency. Hence, in such cases, the demand for the local currency witnesses a sudden increase and the reinsurance company has to bear the loss associated with the rise in forex costs. Unlike, accounting risks, these are actual and permanent costs that reduce the profitability of the underlying reinsurance company.

How do Reinsurers Manage Foreign Exchange Risks?

Over the years, reinsurance companies have become very vigilant about the risk that foreign exchange transactions are bringing on their balance sheets. This is the reason why they have started using several methods in order to avoid undertaking unnecessary foreign exchange risks. Some of these methods have been mentioned below:

1. Passing the Risks onto Individual Insurers: Many reinsurance companies have a strong value proposition. As a result, ceding insurance companies are very keen on transacting with these reinsurance companies. Such companies take advantage of their brand value and competitive position in order to completely avoid foreign exchange risks.

   Such reinsurance companies insist that the premium, as well as loss payments, be made in their local currency and make it a condition to accept any business. The logic is that individual insurance companies can hedge these currency risks in a much simpler manner using derivative contracts. Such hedging is far simpler and cheaper as compared to reinsurance companies having to manage a multicurrency portfolio.

2. Rates Mentioned in the Contracts: In other cases, reinsurance companies do not avoid contracts with foreign currencies. Instead, they fix the rates mentioned in the reinsurance contracts. This means that if the reinsurance contract is denominated in a different currency as compared to the original insurance contract, then the reinsurer considers the exchange rate prevailing on a particular date as fixed.

   For instance, the contract is drawn up based on exchange rates prevailing on the day on which the reinsurance contract was made. This helps the reinsurance company hedge its risks in a more efficient manner.

3. Foreign Exchange Limits in Reinsurance Contracts: In certain cases, reinsurance companies are more liberal. This means that they accept risks in other currencies and also do not force the ceding insurer to fix the exchange rate. Instead of trying to push the risk on the ceding insurer, they try to share the risk. This means that they generally try to put limits on the possible variation of exchange rates.

   For instance, if the exchange rate varies by less than 10%, then the reinsurance company will bear the loss. However, if the rate continues to vary further, then the losses may have to be shared between the reinsurance company and the ceding insurer or sometimes may have to be borne by the ceding insurer alone.

The fact of the matter is that foreign exchange risks are a large part of the reinsurance business. Any reinsurance company cannot be successful until it has found a mechanism to manage these foreign exchange fluctuations.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.