Cyber Risk in Reinsurance
February 12, 2025
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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.
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:
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.
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.
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:
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.
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.
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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