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Why Post Loss funding Commitment fee is less than insurance premium (ART)

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asked Oct 12 in BUS 4027W - Actuarial Risk Management by rohin_jain (980 points)

This is from the Risk Management tools section (Ch 44). Post loss funding is one of the forms of alternative risk transfer. The reason given by ActEd is:

Commitment fee is less than insurance costs (as the cost of the funding will be borne largely post the event) - hence this appears (pre-loss) to be cheaper than conventional insurance

I do not understand this reason. Could one of the reasons also be that in post-loss funding, you are providing a loan (or getting equity) and in both cases you will be receiving something back. For the loan, you would expect the repayment of the loan and for the equity, you would expect dividends and capital growth 

But if you had used reinsurance, the reinsurer would have to provide this funding (as long as you paid your reinsurance premium) and they would not get this sum of money back?

For this reason the commitment fee should be lower than the premium charged for reinsurance. I am not sure if this argument makes sense (and whether this is the same argument laid forward by ActEd). 

1 Answer

+2 votes
answered Oct 16 by MarioGiuricich (1,350 points)

Okay, I can answer this question from the perspective of my research. I would not always agree with your reasoning why reinsurance is relatively more expensive than post-loss funding: in some reinsurance arrangements (but not all), from what I know the reinsurers do get their money back (as odd as that may sound), but in other ways (the types of other ways are not relevant for the ARM course objectives).

The reason for the difference in costs is as follows.

Insurers have two options to protect themselves from super-large losses (e.g. catastrophe-related losses): they can either reinsure it or they can securitise it in the capital markets. The latter markets (which are your investment markets) are much larger and less interlinked than the reinsurance markets, hence the latter are argued to have a much larger appetite for such risks. Therefore, investors in the capital markets (i.e. those who provide post-loss funding) will be willing to pay less to take on this risk (via bespoke post-loss funding arrangements). However, the reinsurance markets are comparatively much smaller and much more interlinked than the capital markets; hence, they will charge more to take on the risk of large losses (e.g. catastrophe risks).

For interest's sake, note that governments are one of the largest providers of post loss funding in the capital markets.

I hope this clears things up.

commented Oct 17 by rohin_jain (980 points)

Hi Mario

Thanks for the detailed answer, makes a lot more sense.

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