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The Costs and Benefits of Reinsurance

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Abstract

Purchasing reinsurance reduces insurers’ insolvency risk by stabilizing loss experience, increasing capacity, limiting liability on specific risks, and/or protecting against catastrophes. Consequently, reinsurance purchase 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 analyze empirically the costs and the benefits of reinsurance for a sample of U.S. property-liability insurers. The results show that reinsurance purchase increases significantly the insurers’ costs but reduces significantly 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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  • J. David Cummins & Georges Dionne & Robert Gagné & Abdelhakim Nouira, 2008. "The Costs and Benefits of Reinsurance," Cahiers de recherche 08-04, HEC Montréal, Institut d'économie appliquée.
  • Handle: RePEc:iea:carech:0804
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    File URL: http://www.hec.ca/iea/cahiers/2008/iea0804_rgagne.pdf
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    1. Froot, Kenneth A., 2001. "The market for catastrophe risk: a clinical examination," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 529-571, May.
    2. Cassandra R. Cole & Kathleen A. McCullough, 2006. "A Reexamination of the Corporate Demand for Reinsurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(1), pages 169-192.
    3. Dionne, Georges & Gagne, Robert & Vanasse, Charles, 1998. "Inferring technological parameters from incomplete panel data," Journal of Econometrics, Elsevier, vol. 87(2), pages 303-327, September.
    4. Berger, Allen N. & Humphrey, David B., 1997. "Efficiency of financial institutions: International survey and directions for future research," European Journal of Operational Research, Elsevier, vol. 98(2), pages 175-212, April.
    5. Ursina B. Meier & J. François Outreville, 2006. "Business cycles in insurance and reinsurance: the case of France, Germany and Switzerland," Journal of Risk Finance, Emerald Group Publishing, vol. 7(2), pages 160-176, March.
    6. Adams, Mike & Hardwick, Philip & Zou, Hong, 2008. "Reinsurance and corporate taxation in the United Kingdom life insurance industry," Journal of Banking & Finance, Elsevier, vol. 32(1), pages 101-115, January.
    7. Doherty, Neil A & Dionne, Georges, 1993. "Insurance with Undiversifiable Risk: Contract Structure and Organizational Form of Insurance Firms," Journal of Risk and Uncertainty, Springer, vol. 6(2), pages 187-203, April.
    8. Hoerger, Thomas J & Sloan, Frank A & Hassan, Mahmud, 1990. "Loss Volatility, Bankruptcy, and the Demand for Reinsurance," Journal of Risk and Uncertainty, Springer, vol. 3(3), pages 221-245, September.
    9. Richard D. Phillips & J. David Cummins & Franklin Allen, 1996. "Financial Pricing of Insurance in the Multiple Line Insurance Company," Center for Financial Institutions Working Papers 96-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
    10. J. David Cummins & Mary A. Weiss, 1998. "Analyzing Firm Performance in the Insurance Industry Using Frontier Efficiency Methods," Center for Financial Institutions Working Papers 98-22, Wharton School Center for Financial Institutions, University of Pennsylvania.
    11. Marek Kaluszka & Andrzej Okolewski, 2008. "An Extension of Arrow's Result on Optimal Reinsurance Contract," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 75(2), pages 275-288.
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    Cited by:

    1. J. Cummins & Georges Dionne & Robert Gagné & A. Nouira, 2009. "Efficiency of insurance firms with endogenous risk management and financial intermediation activities," Journal of Productivity Analysis, Springer, vol. 32(2), pages 145-159, October.
    2. Elena Veprauskaite & Michael Sherris, 2012. "An Analysis of Reinsurance Optimisation in Life," Working Papers 201204, ARC Centre of Excellence in Population Ageing Research (CEPAR), Australian School of Business, University of New South Wales.

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    Keywords

    reinsurance; insolvency risk; risk management; financial intermediation; cost functions; panel data.;

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