Reinsurance and Insurers’ Risk‐Return Profile

Reinsurance has long been known to reduce the ceding company’s underwriting risk and provide capital relief. While the benefits of reinsurance to insurers are abundant, they do not come without a cost. The net value of reinsurance hinges on the trade‐off between the costs and benefits of reinsurance. This study examines the effect of reinsurance on firm performance by utilizing a model of total return to stakeholders and a measure of reinsurance that encompasses both ceded premiums and reinsurance recoverables. Our empirical analyses show that reinsurance as measured by the ratio of reinsurance recoverables to ceded premiums negatively affects risk‐adjusted return on equity. This result, however, does not necessarily mean that insurers should reduce the use of reinsurance. Every firm is different in its risk tolerance and overall objective. For firms that focus more on the risk reduction effect of reinsurance, reinsurance does provide a meaningful channel to hold down the cost of risk.