GFIA & RAB

RAB OPINION: OPEN MARKETS

The power of reinsurance

Supporting the resilience of societies through an open and well-regulated reinsurance market

Reinsurance in the real world

The primary purpose of reinsurance is to spread risks and to protect insurance companies from incurring excessive losses due to large or catastrophic events – both natural and man-made. By transferring a portion of its risk to reinsurers, an insurance company can reduce its exposure to potential losses and stabilise its financial position, allowing it to widen the range of customers and risks it can take on. In essence, reinsurance is insurance for insurers.

While the business-to-business nature of the reinsurance market means that it is often less visible than the primary market, you do not need to look very far to see the positive impact that reinsurers have.

The recent collapse of the Baltimore Francis Scott Key Bridge is likely to be one of the largest, if not the largest, marine losses on record. It is also a very prominent example of how the spreading of risks can help stabilise local insurance markets and how reinsurance can support recovery from catastrophic events.

Another example of the power of reinsurance is the case of Storm Bernd, which was the most expensive natural disaster ever in Germany. According to a survey by Germany’s financial supervisory authority, BaFin, EUR 6.3bn out of the estimated total damages of EUR 8.75bn was borne by reinsurers. Reinsurers paid 72% of all insured claims, and so covered much of the cost of recovery and significantly reduced the extent to which German taxpayers were required to provide disaster relief.

The reinsurance business model

Like any insurer, a reinsurer’s business model is based on the pooling of risk but at a much larger, global scale. By nature, reinsurers operate on a cross-border basis and rely on open reinsurance markets to leverage economies of scale. We diversify risk across different geographical locations as well as across business lines, products, and target groups. As a result, we can absorb a major loss event in one part of the world by compensating the losses against gains from other reinsurance contracts that were not affected by that event.

The benefits of open reinsurance markets are made clear when looking at jurisdictions that are the most vulnerable to natural catastrophes. According to the Organisation for Economic Co-operation and Development (OECD), insurers in countries with relatively high levels of exposure to natural catastrophes, such as Japan and New Zealand, are amongst the most likely to make use of global reinsurance markets, compared to insurers with more limited exposure to major risk events.

“Trade barriers undermine financial stability and hinder rather than boost the development of local reinsurance capacity. Instead, regulatory frameworks that facilitate global risk transfers should be promoted.”

Trade barriers unnecessarily restrict the reinsurance market

Despite the many benefits that open reinsurance markets can bring, the ongoing trend towards the introduction of trade barriers to reinsurance does not seem to slow down.

The most recent report from the Global Reinsurance Forum (GRF), published in April 2024, identified 54 major territories that have implemented, are in the process of implementing or are considering barriers to global reinsurance. Compared to the 45 territories identified in August 2019 by the GRF, this is a 20% increase in less than 5 years.

The reasons behind such discriminatory measures – which can range from collateral requirements to compulsory cessions to local reinsurers and even government interference in risk pricing – are often motivated by a profound misunderstanding of the reinsurance business.

Protectionist measures, such as compulsory cessions to a state-backed reinsurer, have usually one aim: to disincentivise insurers to seek reinsurance internationally and therefore increase local gross written premiums in the country. While, at first glance, this could seem beneficial, it is however the contrary, as such measures lead to less competition and a dangerous concentration of risks locally, to the detriment of the local communities. Unfortunately, many of the negative impacts of concentrating risk and the true cost of restrictions on reinsurance do not become apparent for many years – until a catastrophic event strikes.

Trade barriers can therefore undermine financial stability and hinder rather than boost the development of local reinsurance capacity. Instead, regulatory frameworks that facilitate global risk transfers – for which the RAB has advocated since its creation – should be promoted.

Making reinsurance regulation fit for purpose

Key to the effective regulation of reinsurance markets is recognising that sound capital management from a reinsurance perspective is different from other financial services. Unlike banks, reinsurers do not face a risk of a “run”, when all bank customers withdraw their deposits at the same time, as reinsurers regularly receive upfront premium payments, in addition to being a business-to-business activity – and therefore not having direct contact with consumers.

Additionally, reinsurers need to be able to invest their premium income globally and to move their capital from one jurisdiction to another to pay claims. Restrictions on the free flow of capital make reinsurance cover more expensive. Both the fungibility of capital – the possibility for capital of a single company to fully absorb any kind of losses within the group – and the ability to conduct intra-group transactions across borders are important factors in enabling reinsurers to efficiently allocate capital and thus realise the full benefits of diversification.

Failing to recognise the specific characteristics of reinsurance, especially their cross-border nature, is therefore a threat to the proper functioning of the sector and risks undermining the key role reinsurers have to play to support the resilience and the growth of communities worldwide.

Reinsurance reduces the protection gap

In an ever-increasing volatile environment, there is no doubt about the relevance of reinsurance, especially when supervisors and regulators are clearly emphasising the need to bridge the “protection gap”, i.e. the difference between the amount of insurance that is economically beneficial, and the amount of coverage purchased. Recent events, whether natural catastrophes or man-made disasters, only demonstrate this even more.

While the insurance protection gap is expected to grow, notably due to climate change and demographic shifts, cross-border reinsurance needs to be encouraged, rather than threatened through the use of trade and regulatory barriers.