PartnerRe report assesses strengths, weaknesses of risk transfer mechanisms

The choice of whether to use traditional reinsurance or capital markets to transfer risk “will depend on careful consideration of a number of different factors, including the risk, size of insurer and ability to absorb basis risk,” PartnerRe says in a recent report on insurance-linked securities.PartnerRe’s report, ‘A Balanced Discussion on Insurance-Linked Securities (ILS),’ identifies a number of pros and cons in using both reinsurance and capital markets as risk transfer mechanisms.”While we have opted not to follow the investment banking model, we recognize that for some clients, the ILS market provides a useful, complementary, alternative form of risk transfer to be used in conjunction with their reinsurance programs,” PartnerRe says in the conclusion of the report. The report notes the ILS market has opened up “a wide range of possibilities for primary insurers looking for alternative forms of risk transfer.” But there are a number of advantages and disadvantages associated with each model.For example, there is some credit risk associated with reinsurance i.e. the risk that a reinsurer might not have reserved adequately to pay claims (a risk that can be mitigated through the use of highly-rated reinsurers). On the other hand, catastrophe bonds that provide full collateralization of losses entail no credit risk for the client. The key is that investors generally require better pricing for fully collateralized transactions.There is also a difference in terms of whether a risk transfer mechanism is indemnity-based or index-based. Reinsurance, for example, is based on the cedant insurer’s actual losses. In contrast, capital market ILS structures are index-based, meaning they are based on industry losses or modeled losses, and may therefore result in the bond not paying enough to cover the client’s losses.