Reinsurance allows insurance companies to cede local concentrations of risk and hence manage balance sheet exposure to an acceptable level. Reinsurers themselves have a limited ability to bear the risk associated with large, natural or man-made, events and therefore seek to mitigate their retained exposure by purchasing retrocessional reinsurance.
Coverage may be purchased via a number of different instruments
Cover is available either from rated reinsurance companies or from unrated reinsurers via transactions collateralised either by way of assets or a bank Letter of Credit. Alternatively risk transfer may be achieved via a swap agreement.
It makes increasingly good sense to transfer peak event risk out of the (re)insurance arena (combined capital $1 trillion1) into the capital markets (where the bond markets alone were worth $95 trillion2 at the end of 2010), in the process transforming it from a peak risk concentration into a diversifying asset (modern day alchemy?). The
capital savings by (re)insurers made in mitigating these peak exposures justify risk premiums that far exceed those available for the equivalent default probabilities in the corporate bond market, albeit for a less liquid asset.
1) Swiss Re Sigma no2/2011 – G7 Countries plus Australia
2) Bank of International Settlements – Worldwide
For certain types of transactions, for example industry loss warranties, once the transaction is triggered, based on the predefined trigger type, the full monetary amount contractually agreed is paid out. This is known as a binary payout. Linear payouts, in contrast, scale linearly with the underlying loss upon which the contract is based.