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The costs and benefits of reinsurance

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Abstract

Purchasing reinsurance reduces insurers’ insolvency risk by stabilising loss experience, increasing capacity, limiting liability on specific risks and/or protecting against catastrophes. Consequently, purchasing reinsurance should reduce capital costs. However, transferring risk to reinsurers is expensive. The cost of reinsurance for an insurer can be much larger than the actuarial price of the risk transferred. In this article, we analyse empirically the costs and the benefits of reinsurance for a sample of U.S. property–liability insurers. The results show that the purchase of reinsurance significantly increases insurers’ costs but significantly reduces the volatility of the loss ratio. With purchasing reinsurance, insurers accept to pay higher costs of insurance production to reduce their underwriting risk.

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Notes

  1. On the marginal cost and benefit considerations regarding optimal insurance–reinsurance decisions see the theoretical contribution of Lo (2016). This article formalises the value created by reinsurance with respect to the underwriting capacity of an insurer. It also considers reinsurers’ default possibility and its influence on optimal insurance–reinsurance policies. Other theoretical contributions include Zhuang et al. (2016, 2017), Cheung and Lo (2017) and Lo (2017).

  2. See Dionne et al. (1998) for a discussion on the utilisation of output attributes in the context of transportation firms.

  3. The Hausman test shows that the growth rate of reinsurance and the growth rate of size are endogenous. Thus, we first instrument these two variables using the same set of instruments as in the first stage of cost function estimation.

  4. The cost of equity capital is the average quantity of equity capital held by the insurer during the year multiplied by Equity price. The cost of debt capital is the average quantity of debt capital held by the insurer during the year multiplied by Debt price. Equity price and debt price are defined in the main text.

  5. The chain ladder method is a widely accepted actuarial technique for measuring loss payout patterns. See Taylor (2000).

  6. Surplus is the term used for the book-value of equity capital in the insurance industry.

  7. See Cummins et al. (2009) for details on the computation of the dollar duration of the surplus.

  8. The credit quality term structures are obtained from Bloomberg, and insurer credit quality is obtained from Best’s Key Rating Guide (A.M. Best Co.).

  9. We split listed insurers into three groups based on their A.M. Best rating. For each year, we estimate the cost of equity capital for each group. The prices of the three Fama–French risk factors were obtained from Kenneth French’s website.

  10. The Hausman general test shows that reinsurance, asset–liability risk and financial intermediation variables are endogenous in the cost function specification described by Eq. (3).

  11. Head office state dummy variables control for the effect of state insurance regulations. Regulation could limit managerial discretion in investment and risk management decisions. Many of these dummy variables are statistically significant.

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Acknowledgements

We thank Claire Boisvert for her contribution to the preparation of the manuscript. Financial support by SSHRC Canada and SCOR Reinsurance Company is acknowledged.

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Authors and Affiliations

  1. Temple University, Philadelphia, USA

    J. David Cummins

  2. HEC Montréal, 3000 Chemin de la Côte-Sainte-Catherine, Room 4.454, Montreal, QC, H3T 2A7, Canada

    Georges Dionne

  3. HEC Montréal, Montreal, Canada

    Robert Gagné & Abdelhakim Nouira

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  1. J. David Cummins
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  2. Georges Dionne
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  3. Robert Gagné
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  4. Abdelhakim Nouira
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Correspondence to Georges Dionne.

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Cummins, J.D., Dionne, G., Gagné, R. et al. The costs and benefits of reinsurance. Geneva Pap Risk Insur Issues Pract 46, 177–199 (2021). https://doi.org/10.1057/s41288-021-00216-8

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