Does Reinsurance Need Reinsurers?

The reinsurance market is the secondary market for insurance risks. It has a very specific organization. Direct insurers rarely trade risks with each other. Rather, they cede part of their primary risks to specialized professional reinsurers who have no primary business. This article offers a model of equilibrium in reinsurance and capital markets in which professional reinsurers arise endogenously. Their role is to monitor primary insurers credibly, so that insurers can raise capital more easily. In equilibrium, the financial structure of primary insurers consists of a mix of reinsurance and outside capital. The comparative statics yield empirical predictions which are broadly in line with a number of stylized facts from the reinsurance market.     

Regulatory capital and asset risk transfer

We explore whether life insurers use a unique reinsurance arrangement to manage assets tied to their regulatory capital. Typical reinsurance allows insurers to reduce their regulatory capital by transferring liabilities (reserves), and the associated assets, to reinsurers. With modified coinsurance (ModCo), insurers maintain control of their liabilities and assets while transferring regulatory capital requirements to the reinsurer. Holding fixed an insurer's reported capital, we find that ModCo allows insurers to report higher risk-based capital ratios. Insurers with ModCo are less likely to fire sale downgraded bonds. We also find suggestive evidence of regulatory arbitrage, as most ModCo is purchased from reinsurers in countries with low capital requirements or within the same insurance group.     

Catastrophe Bonds and Reinsurance: The Competitive Effect of Information-Insensitive Triggers

We identify a new benefit of index or parametric triggers. Asymmetric information between reinsurers on an insurer's risk affects competition in the reinsurance market: reinsurers are subject to adverse selection, since only high-risk insurers may find it optimal to change reinsurers. The result is high reinsurance premiums and cross-subsidization of high-risk insurers by low-risk insurers. A contract with a parametric or index trigger (such as a catastrophe bond) is insensitive to information asymmetry and therefore alters the equilibrium in the reinsurance market. Provided that basis risk is not too high, the introduction of contracts with parametric or index triggers provides low-risk insurers with an alternative to reinsurance contracts, and therefore leads to less cross-subsidization in the reinsurance market.     

Leverage and reinsurance effects on loss reserves in the United Kingdom’s property–casualty insurance industry

We examine the relation between loss reserving errors, leverage and reinsurance in the UK’s property–casualty insurance industry. We find that financially weak insurers under-estimate reserves to reduce leverage, and so pre-empt costly regulatory scrutiny. However, at very high leverage, insurers over-reserve, suggesting a non-linear relation between leverage and reserving policy. We also investigate whether monitoring by reinsurers reduces reserving errors, and find that highly reinsured insurers are less likely to make loss reserve errors. However, the use of proportional reinsurance does not affect loss reserve accuracy.     

The structure of the global reinsurance market: An analysis of efficiency,scale, and scope

We estimate economies of scale and scope as well as cost and revenue efficiency to explain the structure of the global reinsurance market, where large reinsurers dominate but both diversified and specialized reinsurers are competitive. The costs and benefits of size and product diversification are particularly relevant to the reinsurance industry, as risk diversification is central to the industry's business model. We find that reinsurers with total assets less than USD 2.9 billion exhibit scale economies, while those with total assets greater than USD 15.5 billion do not. Large reinsurers are characterized by high cost efficiency, while small reinsurers exhibit superior efficiency only when specialized. Large reinsurers also exhibit revenue scope economies when operating both life and nonlife reinsurance. Moreover, the evidence is in line with the efficient structure hypothesis: cost-efficient reinsurers can charge lower prices without sacrificing profitability.     

A Reexamination of the Corporate Demand for Reinsurance

This study examines the effect of the state of the international reinsurance market on the demand for reinsurance by U.S. insurers using data from the years 1993 through 2000. Both the overall demand for reinsurance and the utilization of foreign reinsurance by U.S. insurers are explored. In addition to supporting the findings of prior literature related to the traditional motives for the corporate demand for insurance, evidence indicates that the state of the U.S. reinsurance industry impacts the amount of reinsurance demanded by U.S. insurers. The study also investigates reasons why U.S. insurers utilize a reinsurance program composed of both U.S. and foreign reinsurers. The results indicate that the decision to utilize some percentage of foreign reinsurance is driven primarily by the financial and operational characteristics of the ceding company such as firm size, group affiliation, and organizational form. However, no support is found for the hypothesis that possible differences between the foreign and U.S. reinsurance markets impact the decision to utilize foreign reinsurance.     

Adverse Selection in Reinsurance Markets

This paper looks for evidence of adverse selection in the relationship between primary insurers and reinsurers. We test the implications of a model in which informational asymmetry—and therefore, its negative consequences—decline over time. Our tests involve a data panel consisting of U.S. property-liability insurance firms that reported to the National Association of Insurance Commissioners during the period 1993–2012. We find that the amount of reinsurance, insurer profitability, and insurer credit quality all increase with the tenure of the insurer–reinsurer relationship.     

On the economics of the longevity risk transfer market

We present a model of a longevity risk transfer market with different market players (primary insurers, reinsurers, and capital market investors) and investigate how market dynamics and the market players' roles evolve with progressing market saturation. We find that reinsurers' appetite for longevity risk is the key driver in the early stage of market development. Since diversification benefits with other businesses decrease with every transaction, the reinsurance market is intrinsically antimonopolistic. With the increasing saturation of the reinsurance sector as a whole, its competitiveness shrinks leading to rising expected risk-adjusted returns for capital market investors. We show that in a saturated market, reinsurers should assume the entire longevity risk from primary insurers, diversify it within their business mix, and subsequently pass on only specific (nondiversifiable) components of the longevity risk to the capital markets. Our findings provide valuable suggestions on how to make the best use of the market's limited risk absorption capacity.     

Die Aufsicht über Rückversicherungsunternehmen nach Solvency II

The impacts of the new regulatory system “Solvency II” on the reinsurance sector are not foreseeable in all details yet. This is true especially with regard to the business aspects of insurance and reinsurance. The legal consequences can be summarized as follows: (1) Solvency II for reinsurers and for primary insurers likewise stands for a paradigm shift in regulation. (2) With Solvency II primary insurance regulation and reinsurance regulation will be more aligned as has been the case according to the Solvency I system so far. (3) The specifics of reinsurance business will be taken into account in the Solvency II-directive as well. Many special provisions which are known from the reinsurance directive will remain in place.     

Risk-sharing function in internal capital markets: Evidence from intragroup reinsurance activities

This study explicitly investigates the risk-sharing function of internal capital markets by analyzing intragroup reinsurance (a substitute for capital) activities in the United States' non-life insurance sector. We find supporting evidence that intragroup reinsurance participants are generally associated with smoother income flows, and such an income smoothing effect exists for both ceding and assuming firms. Further to prior studies, we find that internal reinsurance ceded exerts both direct and indirect effects on premiums growth in the aftermath of the financial crisis in 2007 and 2008. In addition to direct capacity support, the reduction in income volatility is another channel through which intragroup reinsurance enhances ceding firms' premiums growth. In the presence of market turmoil, the risk-sharing function can lower member firms' insolvency risk and thus enable them to pursue business growth.     

The market for catastrophe risk: a clinical examination

This paper examines the market for catastrophe event risk – i.e., financial claims that are linked to losses associated with natural hazards, such as hurricanes and earthquakes. Risk management theory suggests protection by insurers and other corporations against the largest cat events is most valuable. However, most insurers purchase relatively little cat reinsurance against large events, and premiums are high relative to expected losses. To understand why the theory fails, we examine transactions that look to capital markets, rather than traditional reinsurance markets, for risk-bearing capacity. We develop eight theoretical explanations and find the most compelling to be supply restrictions associated with capital market imperfections and market power exerted by traditional reinsurers.     

The Design of Private Reinsurance Contracts

This article examines the effect of asymmetric information on the trading of underwriting risk between insurers and reinsurers and how it is mitigated in a context of long-term relationships. It begins by explaining how information problems affect the efficiency of the allocation of risk between insurers and reinsurers and how long-term implicit contracts allow the inclusion of new information in the pricing of reinsurance coverage. A key feature of these relationships is the reliance on loss-contingent rebates and commissions in the pricing of reinsurance coverage. We argue that when information is revealed only over time, long-term implicit contracts between insurers and reinsurers allow the inclusion of new information into reinsurance pricing. Because of this feature, the allocation of risk between insurers and reinsurers is more efficient. Specifically, such arrangements lead to more reinsurance coverage, higher insurer profits, and lower expected distress in the industry. Journal of Economic Literature Classification Numbers: G22, G13, L15, D81.     

Foreign exchange exposure: Evidence from the U.S. insurance industry

We study the foreign exchange exposure of U.S. insurers. The evidence shows that no systematic difference exists in the currency risk profiles of life and non-life segments within the insurance industry. This suggests that life and non-life insurers have similar risk exposure management strategies arising from similar risk pooling and financial intermediary functions. The empirical results reveal that a sizable proportion of U.S. insurers are exposed to foreign exchange movements against the seven largest U.S. trade partners in insurance services (U.K., Japan, Switzerland, Netherlands, France, Germany and Canada). Significant operational and size effects are also documented and we find that the frequency of foreign exchange exposure increases with time horizon.     

Efficiency in the international insurance industry: A cross-country comparison

The purpose of this paper is to provide new empirical evidence on frontier efficiency measurement in the international insurance industry, a topic of great interest in the academic literature during the last several years. A broad efficiency comparison of 6462 insurers from 36 countries is conducted. Different methodologies, countries, organizational forms, and company sizes are compared, considering life and non-life insurers. We find a steady technical and cost efficiency growth in international insurance markets from 2002 to 2006, with large differences across countries. Denmark and Japan have the highest average efficiency, whereas the Philippines is the least efficient. Regarding organizational form, the results are not consistent with the expense preference hypothesis, which claims that mutuals should be less efficient than stocks due to higher agency costs. Only minor variations are found when comparing different frontier efficiency methodologies (data envelopment analysis, stochastic frontier analysis).     

Insurer pricing and consumer welfare: evidence from Medigap

This article examines the welfare impact of imperfect competition in the Medicare supplement insurance (Medigap) market. Two firms control nearly three fourths of the Medigap market, and premiums exceed claims by over 25%. I find that a low price elasticity and consumers' brand preferences lead firms to engage in substantial marketing and price above cost. Therefore, the strategic behavior of insurers facing relatively inelastic demand is critical in explaining poor market performance. I also find that insurers do not capture all of the rents in this market; rents also accrue to actors who perform marketing functions, including agents and brokers.     

CAT Bonds and Other Risk-Linked Securities: State of the Market and Recent Developments

This article reviews the current status of the market for catastrophic risk (CAT) bonds and other risk-linked securities. CAT bonds and other risk-linked securities are innovative financial vehicles that have an important role to play in financing mega-catastrophes and other types of losses. The vehicles are especially important because they access capital markets directly, exponentially expanding risk-bearing capacity beyond the limited capital held by insurers and reinsurers. The CAT bond market has been growing steadily, with record amounts of risk capital raised in 2005, 2006, and 2007. CAT bond premia relative to expected losses covered by the bonds have declined by more than one-third since 2001. CAT bonds now appear to be priced competitively with conventional catastrophe reinsurance and comparably rated corporate bonds. CAT bonds have grown to the extent that they now play a major role in completing the market for catastrophic-risk finance and are spreading to other lines such as automobile insurance, life insurance, and annuities. CAT bonds are not expected to replace reinsurance but to complement the reinsurance market by providing additional risk-bearing capacity. Other innovative financing mechanisms such as risk swaps, industry loss warranties, and sidecars also are expected to continue to play an important role in financing catastrophic risk.     

Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers

This article builds on Froot and Stein in developing a framework for analyzing the risk allocation, capital budgeting, and capital structure decisions facing insurers and reinsurers. The model incorporates three key features: (i) value‐maximizing insurers and reinsurers face product‐market as well as capital‐market imperfections that give rise to well‐founded concerns with risk management and capital allocation; (ii) some, but not all, of the risks they face can be frictionlessly hedged in the capital market; and (iii) the distribution of their cash flows may be asymmetric, which alters the demand for underwriting and hedging. We show these features result in a three‐factor model that determines the optimal pricing and allocation of risk and capital structure of the firm. This approach allows us to integrate these features into: (i) the pricing of risky investment, underwriting, reinsurance, and hedging; and (ii) the allocation of risk across all of these opportunities, and the optimal amount of surplus capital held by the firm.     

Actuarial Surplus Management in United Kingdom Life Insurance Firms

This study uses 1991–99 data gathered from the United Kingdom's life insurance industry to test empirically the notion that the reported annual surplus of a life insurer may be influenced by four firm‐specific characteristics: namely, reinsurance, output mix, organizational form and firm size. Consistent with expectations, the results indicate that the annual reported surplus is positively related to reinsurance and firm size and negatively related to the degree of product diversification. Contrary to our expectations, however, we find no evidence that proprietary (stock) life insurers tend to report higher annual surpluses than mutual life insurers.     

Cost efficiency and board composition under different takaful insurance business models

This study examines the link between cost efficiency and board composition in non-life takaful insurance firms operating in 17 Islamic countries using panel data for 2004–2007. Nonparametric data envelopment analysis (DEA) is used to compute cost efficiency scores and a second-stage logit transformation regression model is then employed to test the influence of corporate characteristics on these efficiencies. We find that average levels of cost efficiency in takaful insurance markets mirror the efficiency in developed non-life insurance markets. The relative influence of board composition, such as the proportion of non-executive directors on the board, on the cost efficiency of takaful insurers depends on its interaction with other firm-specific characteristics such as board size. Hence, the effect of corporate governance systems on the cost efficiency of takaful insurers can be complicated by various firm-specific factors. Our results could have important commercial and policy implications.     

Market segmentation,performance differences and strategic orientation - the case of German reinsurers

We apply the concept of strategic groups to the German reinsurance market. We use a cluster analysis to subdivide reinsurance companies into strategic groups and analyze the effect of a set of strategic choice variables on their performance. Furthermore, we examine the impact of the financial crisis of 2008 on the reinsurance sector. Our dataset encompasses 142 firm-year observations for the years 2004 until 2012. Our results indicate the existence of three strategic groups in the German reinsurance market. Moreover, we find that most strategic choice variables that characterize the individual strategic groups affect the reinsurers’ level of performance. Finally, we find that the reinsurers’ performance increased in the aftermath of the financial crisis. This holds in particular for professional reinsurance companies.