Insurance, Reinsurance and Pools mandated by governments

Report Highlight:

Risk Pooling in a broad sense, a risk pool is any mechanism for sharing risk among two or more parties. Insurance, reinsurance, and pools mandated by government are all examples of risk pools.

The main economic benefit of pooling is an improved ability to plan and budget for sudden and unexpected losses.

The main risk management benefits of risk pooling are risk diversification and scale. In some cases, a pool may provide the valuable collateral benefits of focusing attention on catastrophe risk management and facilitating communication and knowledge sharing among pool participants.

The primary drawbacks of pooling are related to the assumption of other parties’ risk, which may be subject to moral hazard, asymmetric information, or differences of opinion regarding the proportion of cost assumed by each pool participant. As used in this document, a “standalone risk pool” is a special risk pool established to satisfy a particular risk transfer need that is not addressed adequately in existing risk transfer markets. This definition excludes pass-through entities and other mechanisms established to repackage risk for existing third-party risk takers.

Thus, a standalone risk pool is generally self-funded and retains most or all risk within the pool. A stand-alone risk pool may be viable under certain conditions:

• Pooled risks are similar in terms of economics and hazard assessment (for example, it would be ineffective to pool a $10 million potential wind loss with a $50 billion potential earthquake loss).

• Any information asymmetries can be adequately resolved.

• An enforceable pooling agreement can be negotiated among pool participants.

• Pool participants have sufficient financial strength to sustain the pool over time, or appropriate credit enhancement is provided by a financially strong third party.

• The number of pool participants is sufficiently high to keep loss costs relatively steady and predictable. Pool participants see benefits that outweigh costs (in the long run, this means they should receive payments after most significant catastrophic events).

However, the concept of a stand-alone risk pool has been used successfully as a starting point for building catastrophe risk transfer programs in regions such as the Caribbean and in countries such as Indonesia.

Pooling structures like Caribbean Catastrophe Risk Insurance Facility operate on a stand-alone basis up to a point but may also secure capacity for the costliest events through reinsurance, securitization, and other risk transfer mechanisms. A pool may begin as a stand-alone pool with the intent to transfer risk to third parties when the pool’s track record provides sufficient data to transfer risk to third-party risk takers. Stand-alone catastrophe risk pools are sometimes proposed when a catastrophe in one area reduces the capital and capacity of global reinsurance companies, resulting in increased reinsurance prices everywhere. While a stand-alone pool can charge lower premiums in the short term, critics question whether such pools can survive significant catastrophes in the long run when premiums are set below market rates by design. In the workshop on Asian megacities, all panellists supported the application of risk pooling principles to manage megacity risk. However, it became clear early in the first session that the bulk of catastrophe risk faced by Asian megacities would not satisfy many of the conditions that would make a stand-alone risk pool viable. Although there may be special cases in which a new risk pool might be established for a particular risk, the panel discussions emphasized the need to study the special requirements of each megacity individually before pursuing a particular program such as a regional risk pool.