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Moral Hazard in Reinsurance Markets

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  • Neil Doherty
  • Kent Smetters

Abstract

This article attempts to identify moral hazard in the traditional reinsurance market. We build a multiperiod principal-agent model of the reinsurance transaction from which we derive predictions on premium design, monitoring, loss control, and insurer risk retention. We then use panel data on U.S. property liability reinsurance to test the model. The empirical results are consistent with the model's predictions. In particular, we find evidence for the use of loss-sensitive premiums when the insurer and reinsurer are not affiliates (i.e., not part of the same financial group), but little or no use of monitoring. In contrast, we find evidence for the extensive use of monitoring when the insurer and reinsurer are affiliates, where monitoring costs are lower. Copyright The Journal of Risk and Insurance.

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Bibliographic Info

Article provided by The American Risk and Insurance Association in its journal The Journal of Risk and Insurance.

Volume (Year): 72 (2005)
Issue (Month): 3 ()
Pages: 375-391

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Handle: RePEc:bla:jrinsu:v:72:y:2005:i:3:p:375-391

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References

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  1. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  2. Cremer, Jacques, 1995. "Arm's Length Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 275-95, May.
  3. Randall Geehan, 1977. "Returns to Scale in the Life Insurance Industry," Bell Journal of Economics, The RAND Corporation, vol. 8(2), pages 497-514, Autumn.
  4. Bond, Eric W. & Crocker, Keith J., 1997. "Hardball and the soft touch: The economics of optimal insurance contracts with costly state verification and endogenous monitoring costs," Journal of Public Economics, Elsevier, vol. 63(2), pages 239-264, January.
  5. Kenneth A. Froot & Paul G.J. O'Connell, . "On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance," Center for Financial Institutions Working Papers 97-24, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Keith J. Crocker & John Morgan, 1998. "Is Honesty the Best Policy? Curtailing Insurance Fraud through Optimal Incentive Contracts," Journal of Political Economy, University of Chicago Press, vol. 106(2), pages 355-375, April.
  7. Allen, Franklin & Gale, Douglas, 1997. "Financial Markets, Intermediaries, and Intertemporal Smoothing," Journal of Political Economy, University of Chicago Press, vol. 105(3), pages 523-46, June.
  8. Bruce C. Greenwald & Joseph E. Stiglitz, 1994. "Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior," NBER Working Papers 3359, National Bureau of Economic Research, Inc.
  9. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  10. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  11. Richard A. Lambert, 1983. "Long-Term Contracts and Moral Hazard," Bell Journal of Economics, The RAND Corporation, vol. 14(2), pages 441-452, Autumn.
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Citations

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Cited by:
  1. Benjamin Lorent, 2006. "Raisons fondamentales d'une régulation prudentielle du secteur des assurances," Brussels Economic Review, ULB -- Universite Libre de Bruxelles, vol. 49(3), pages 203-244.
  2. John Lewis, 2010. "Reinsurers as financial intermediaries in the market for catastrophic risk," DNB Occasional Studies 802, Netherlands Central Bank, Research Department.
  3. Lemoyne de Forges, Sabine & Bibas, Ruben & Hallegatte, Stephane, 2011. "A dynamic model of extreme risk coverage : resilience and efficiency in the global reinsurance market," Policy Research Working Paper Series 5807, The World Bank.
  4. repec:idb:brikps:11118 is not listed on IDEAS
  5. Starbird, S. Andrew & Amanor-Boadu, Vincent & Roberts, Tanya, 2008. "Traceability, Moral Hazard, and Food Safety," 2008 International Congress, August 26-29, 2008, Ghent, Belgium 43840, European Association of Agricultural Economists.
  6. Sabine Lemoyne De Forges & Ruben Bibas & Hallegatte Stéphane, 2001. "A dynamic model of extreme risk coverage : Resilience and e fficiency in the global reinsurance market," Working Papers halshs-00800460, HAL.
  7. Bender, Klaus & Richter, Andreas, 2002. "Optimales Vertragsdesign bei moralischem Risiko in der Rückversicherung," Working Papers on Risk and Insurance 9, University of Hamburg, Institute for Risk and Insurance.
  8. Franke, Günter & Krahnen, Jan Pieter, 2008. "The future of securitization," CFS Working Paper Series 2008/31, Center for Financial Studies (CFS).
  9. Guillaume Plantin, 2003. "Does reinsurance need reinsurers?," LSE Research Online Documents on Economics 24848, London School of Economics and Political Science, LSE Library.

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