Feasibility analysis of the reinsurance secondary market: An exploratory study

Feasibility analysis of the reinsurance secondary market: An exploratory study

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Speaker(s): Ziyan Wang (University of Sao Paulo)

Reinsurance is the most frequently used tool by insurance companies to reduce the level and the volatility of the aggregated losses' burden under their responsibility. Despite the financial and strategic benefits generated by the operation, all insurers must establish minimum reserves to guarantee the coverage of its exposures to the other entities' default, known as Credit Risk Capital. As part of this value, the outstanding reinsurance recoverable are usually a high sum of the insurer's balance sheet and, when the recovery period (aging) extends for long periods, the nominal volume can intensively depreciate due to inflation levels. The last matter becomes particularly relevant on countries with chronic and persistent inflation, such as Brazil.

Thus, it is the insurer's interest to anticipate it, through a derivative backed by the principal amount, because, in addition to paying the claims more quickly to the insured, it is possible to transfer the financial burden of a potential default to the reinsurer. Conversely, the investor could earn profits assuming the risks of the primary operations, besides the bonus derived from the capital reserve reduction because of the reduced risk exposure by the insurance company. This study aims to assess this derivative's market feasibility, considering evidences of the parameters from the Brazilian market, through simulations based in different scenarios. The first results of the bond, solely based on expectations of future inflation and the historical aging of losses, were not attractive to the investor. However, when also considering the counterparty's credit rating, combined to the bonus offered by the insurer and to the market's average margin of error of the inflation's projections, the findings reveal positive returns and low risks, proving the feasibility of this operation.

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