Reinsurance Vs Securitization
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:
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.
- Benefits of Reinsurance
- Key Differences Between Insurance and Reinsurance
- How Inflation Impacts Reinsurance
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