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Article
Publication date: 1 February 2005

Lixin Zeng

Demonstrates the feasibility of, and introduces a practical approach to enhancing, reinsurance efficiency using index‐based instruments.

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Abstract

Purpose

Demonstrates the feasibility of, and introduces a practical approach to enhancing, reinsurance efficiency using index‐based instruments.

Design/methodology/approach

First reviews the general mathematical framework of reinsurance optimization. Next, illustrates how index‐based instruments can potentially enhance reinsurance efficiency through a simple yet self‐contained example. The simplicity allows the analytical examination of the cost and benefits of an index‐based contract. Finally, introduces a real‐world model that optimizes index‐based reinsurance instruments using the genetic algorithm.

Findings

Identifies the key factors that determine the efficiency of index‐based reinsurance contracts and demonstrates that, in the property catastrophe reinsurance market, the combined effect of these factors frequently allows the construction of an index‐based hedging program that is more efficient than a traditional excess‐of‐loss reinsurance contract. A robust optimization model based on the genetic algorithm is introduced and shown to be effective in optimizing index‐based reinsurance contracts.

Research limitations/implications

Most financial optimization procedures are subject to parameter risk, which can adversely affect the robustness of their solutions. The reinsurance optimization approach presented in this paper is not completely immune from this problem. It remains a challenging problem for actuarial researchers and practitioners.

Practical implications

The concept and method proposed in this paper can be applied to designing real‐world reinsurance programs.

Originality/value

This paper makes two contributions to the risk finance literature: a systematic approach for evaluating the costs and benefits of index‐based reinsurance instruments, and an innovative and practical model for optimizing reinsurance efficiency.

Details

The Journal of Risk Finance, vol. 6 no. 1
Type: Research Article
ISSN: 1526-5943

Keywords

Article
Publication date: 22 February 2022

Heike Bockius and Nadine Gatzert

The purpose of this article is to investigate the impact of counterparty risk on the basis risk of industry loss warranties as well as on reinsurance with and without…

Abstract

Purpose

The purpose of this article is to investigate the impact of counterparty risk on the basis risk of industry loss warranties as well as on reinsurance with and without collateral under different dependence structures. The authors additionally compare the solvency and Sharpe ratio for different premium loadings and contract parameters.

Design/methodology/approach

The authors propose a model framework extension to account for the counterparty risk of risk transfer arrangements. Copulas are used to also take into account non-linear dependencies between risk factors, and Monte Carlo simulation is employed to derive numerical results and to conduct sensitivity analyses.

Findings

The authors show that the impact of counterparty risk is particularly pronounced for higher degrees of dependencies and tail dependent losses, i.e. in cases of basis risk levels that appear low if counterparty risk is not considered. With respect to counterparty risk management, the authors find that already partial collateralization limits counterparty and basis risk to more acceptable levels.

Practical implications

The study results are particularly relevant to practitioners, as insurers may not only underestimate the “true” basis risk of index-linked instruments, but also the effect of counterparty risk of reinsurance contracts along with the consequences for solvency and profitability.

Originality/value

The authors extend existing literature by allowing for the (partial) default of industry loss warranties and reinsurance under different dependence structures. Furthermore, the authors include profitability in addition to risk considerations. The interaction effects between counterparty risk and the basis risk of index-based alternative risk transfer instruments are largely unstudied, despite their considerable relevance in practice.

Details

The Journal of Risk Finance, vol. 23 no. 3
Type: Research Article
ISSN: 1526-5943

Keywords

Article
Publication date: 13 August 2021

Yang Zhao, Jin-Ping Lee and Min-Teh Yu

Catastrophe (CAT) events associated with natural catastrophes and man-made disasters cause profound impacts on the insurance industry. This research thus reviews the…

Abstract

Purpose

Catastrophe (CAT) events associated with natural catastrophes and man-made disasters cause profound impacts on the insurance industry. This research thus reviews the impact of CAT risk on the insurance industry and how traditional reinsurance and securitized risk-transfer instruments are used for managing CAT risk.

Design/methodology/approach

This research reviews the impact of CAT risk on the insurance industry and how traditional reinsurance and securitized risk-transfer instruments are used for managing CAT risk. Apart from many negative influences, CAT events can increase the net revenue of the insurance industry around CAT events and improve insurance demand over the post-CAT periods. The underwriting cycle of reinsurance causes inefficiencies in transferring CAT risks. Securitized risk-transfer instruments resolve some inefficiencies of the reinsurance market, but are subject to moral hazard, basis risk, credit risk, regulatory uncertainty, etc. The authors introduce some popular securitized solutions and use Merton's structural framework to demonstrate how to value these CAT-linked securities. The hybrid solutions by combining reinsurance with securitized CAT instruments are expected to offer promising applications for CAT risk management.

Findings

The authors introduce some popular securitized solutions and use Merton's structural framework to demonstrate how to value these CAT-linked securities. The hybrid solutions by combining reinsurance with securitized CAT instruments are expected to offer promising applications for CAT risk management.

Originality/value

This research reviews a broad array of impacts of CAT risks on the (re)insurance industry. CAT events challenge (re)insurance capacity and influence insurers' supply decisions and reconstruction costs in the aftermath of catastrophes. While losses from natural catastrophes are the primary threat to property–casualty insurers, the mortality risk posed by influenza pandemics is a leading CAT risk for life insurers. At the same time, natural catastrophes and man-made disasters cause distinct impacts on (re)insures. Man-made disasters can increase the correlation between insurance stocks and the overall market, and natural catastrophes reduce the above correlation. It should be noted that huge CAT losses can also improve (re)insurance demand during the postevent period and thus bring long-term effects to the (re)insurance industry.

Details

China Finance Review International, vol. 11 no. 4
Type: Research Article
ISSN: 2044-1398

Keywords

Article
Publication date: 28 June 2013

Zhiqiang Yan

The purpose of this paper is to test for the existence of residual moral hazard in the three largest US reinsurance markets over the period 1995‐2000 and examine the…

Abstract

Purpose

The purpose of this paper is to test for the existence of residual moral hazard in the three largest US reinsurance markets over the period 1995‐2000 and examine the effectiveness of retention limit, experience rating and long‐term contracting relationship in controlling for moral hazard.

Design/methodology/approach

This paper focuses on one peculiar feature in the insurance industry, group affiliation, and tests the presence of residual moral hazard in reinsurance markets. This approach may enable moral hazard to be separated from adverse selection. Moreover, two different econometric methods are employed for the empirical tests: the non‐parametric matching estimators method and the parametric fixed effects model, which may enhance the robustness of the results.

Findings

The author finds that, over the period 1995‐2000, residual moral hazard does not exist in the private passenger auto liability and product liability reinsurance markets, but might exist in the homeowners reinsurance market. This finding suggests that the US reinsurance markets are efficient overall and moral hazard is not a serious issue over this period of time. In addition, the author finds that retention limit is effectively used by reinsurers to mitigate the moral hazard problem, whereas experience rating and long‐term contracting relationship are either not used or not effective in controlling the loss experience of reinsurance.

Practical implications

US reinsurance markets are efficient overall and moral hazard is not a serious issue.

Originality/value

The significance of this paper is multifaceted. First, it investigates moral hazard in reinsurance markets by examining internal and external reinsurance jointly. Second, instead of directly examining the correlation between risk and coverage, this paper tests for the presence of residual moral hazard in reinsurance markets. Moreover, the author employs two different econometric methods: the non‐parametric matching estimators method and the parametric fixed effects model, which may enhance the robustness of the results. Third, the use of panel data makes it possible to explore the roles of retention limit, experience rating and long‐term contracting relationship in mitigating the moral hazard problem.

Details

Managerial Finance, vol. 39 no. 8
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 16 November 2012

J. François Outreville

This paper aims to examine the relationship between geographical diversification and the underwriting performance for the world's largest reinsurance groups. It also aims…

Abstract

Purpose

This paper aims to examine the relationship between geographical diversification and the underwriting performance for the world's largest reinsurance groups. It also aims to verify that the form and nature of the relationship between diversification and performance follow an S‐shaped curve with increased diversification of the largest reinsurance groups.

Design/methodology/approach

Analysis in the paper is based on the concept of Geographical Spread Index defined and calculated by UNCTAD. Data on largest reinsurance groups in the world are published annually by Standard & Poor's for only a limited number of reinsurance groups. To overcome the small sample problem, a re‐sampling procedure from the original sample, similar to a bootstrap sample, is used to validate the results.

Findings

The results show that, overall, international geographical diversification has a positive effect on a reinsurance firm's underwriting performance but that this relationship is not linear. It rather follows an S‐shaped curve. Although data limitation does not allow more sophisticated investigations, the results reported in this paper are nevertheless significant. It seems that at an early stage of expansion in proximate markets there are efficiency gains for the firm. With increased internationalization there may be a diminution in performance because of higher transaction costs or learning costs for new markets. Further expansion in foreign markets brings back efficiency and higher performance.

Research limitations/implications

Only cross‐section data for a small sample of companies are available and therefore it is not possible to analyze the dynamics of geographical diversification. A firm may deliberately expand for long‐term strategy reasons such as market share even though this is detrimental to medium‐run performance. Also, the analysis cannot provide any answer to the existence or not of a maximum level of international diversification beyond which performance would decline.

Originality/value

In the literature on firm diversification in the financial services sector, product diversification and performance has received significant attention with mixed results but except for a few papers, the internationalization aspect has not been examined. The reinsurance sector is important since reinsurance activities are, by nature, more geographically diversified than other financial activities. Furthermore, the largest European reinsurance groups dominate this worldwide market and many reinsurance companies have, in the past decade, increased their foreign direct investment and acquired other companies in part because of the belief that only very large players will have the cost advantages necessary to remain competitive in global markets.

Details

Multinational Business Review, vol. 20 no. 4
Type: Research Article
ISSN: 1525-383X

Keywords

Article
Publication date: 6 November 2009

Christopher L. Culp and Kevin J. O'Donnell

Property and casualty (“P&C”) insurance companies rely on “risk capital” to absorb large losses that unexpectedly deplete claims‐paying resources and reduce underwriting…

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Abstract

Purpose

Property and casualty (“P&C”) insurance companies rely on “risk capital” to absorb large losses that unexpectedly deplete claims‐paying resources and reduce underwriting capacity. The purpose of this paper is to review the similarities and differences between two different types of risk capital raised by insurers to cover losses arising from natural catastrophes: internal risk capital provided by investors in insurance company debt and equity; and external risk capital provided by third parties. The paper also explores the distinctions between four types of external catastrophe risk capital: reinsurance, industry loss warranties, catastrophe derivatives, and insurance‐linked securities. Finally, how the credit crisis has impacted alternative sources of catastrophe risk capital in different ways is considered.

Design/methodology/approach

The discussion is based on the conceptual framework for analyzing risk capital developed by Merton and Perold.

Findings

In 2008, the P&C insurance industry was adversely affected by significant natural catastrophe‐related losses, floundering investments, and limited access to capital markets, all of which put upward pressure on catastrophe reinsurance premiums. But the influx of new risk capital that generally accompanies hardening markets has been slower than usual to occur in the wake of the credit crisis. Meanwhile, disparities between the relative costs and benefits of alternative sources of catastrophe risk capital are even more pronounced than usual.

Originality/value

Although many insurance companies focus on how much reinsurance to buy, this paper emphasizes that a more important question is how much risk capital to acquire from external parties (and in what form) vis‐à‐vis investors in the insurance company's own securities.

Details

The Journal of Risk Finance, vol. 10 no. 5
Type: Research Article
ISSN: 1526-5943

Keywords

Article
Publication date: 1 March 2006

Ursina B. Meier and J. François Outreville

This article aims to examine the existence of an underwriting cycle in property‐liability insurance for France, Germany and Switzerland (primary markets) and for the…

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Abstract

Purpose

This article aims to examine the existence of an underwriting cycle in property‐liability insurance for France, Germany and Switzerland (primary markets) and for the European reinsurance industry. It is also aimed to test how the two markets are related with each other in each country and how they influence each other.

Design/methodology/approach

Loss ratio data for France, Germany and Switzerland are used for the recent period 1982‐2001 in connection with the price of reinsurance in Europe as well as the money market rate. To test for the existence of cycles and calculate their length auto‐regressive processes of second order are applied.

Findings

There are cross‐country differences for the primary markets of the three countries. The reinsurance price index is highly cyclical with a calculated cycle length of almost nine years. It is shown that the reinsurance price index has a strong influence on the primary market loss ratios of the three countries studied.

Originality/value

With the exception of two studies examining the impact of reinsurance on insurance prices and profits, there has been no research as yet to determine the role of reinsurance on the cyclical behavior of underwriting results. This gap is filled here by an empirical study on three European countries.

Details

The Journal of Risk Finance, vol. 7 no. 2
Type: Research Article
ISSN: 1526-5943

Keywords

Article
Publication date: 26 July 2013

Lysa Porth, Ken Seng Tan and Chengguo Weng

The purpose of this paper is to analyze the optimal reinsurance contract structure from the crop insurer's perspective.

Abstract

Purpose

The purpose of this paper is to analyze the optimal reinsurance contract structure from the crop insurer's perspective.

Design/methodology/approach

A very powerful and flexible empirical‐based reinsurance model is used to analyze the optimal form of the reinsurance treaty. The reinsurance model is calibrated to unique data sets, including private reinsurance experience for Manitoba, and loss cost ratio (LCR) experience for all of Canada, under the assumption of the standard deviation premium principle and conditional tail expectation risk measure.

Findings

The Vasicek distribution is found to provide the best statistical fit for the Canadian LCR data, and the empirical reinsurance model stipulates that a layer reinsurance contract structure is optimal, which is consistent with market practice.

Research limitations/implications

While the empirical reinsurance model is able to reproduce the optimal shape of the reinsurance treaty, the model produces some inconsistencies between the implied and observed attachment points. Future research will continue to explore the reinsurance model that will best recover the observed market practice.

Practical implications

Private reinsurance premiums can account for a significant portion of a crop insurer's budget, therefore, this study should be useful for crop insurance companies to achieve efficiencies and improve their risk management.

Originality/value

To the best of the authors' knowledge, this is the first paper to show how a crop insurance firm can optimally select a reinsurance contract structure that minimizes its total risk exposure, considering the total losses retained by the insurer, as well as the reinsurance premium paid to private reinsurers.

Article
Publication date: 4 February 2021

Jin Park, Byeongyong Paul Choi and Chia-Ling Ho

This study is designed to investigate how the use of reinsurance affects the primary insurers' profitability and pricing on their insurance products.

Abstract

Purpose

This study is designed to investigate how the use of reinsurance affects the primary insurers' profitability and pricing on their insurance products.

Design/methodology/approach

This study examines the impact of reinsurance on the insurers’ profitability using a two stage least square to control the endogeneity problem with a reinsurance variable. The study analyzes 11,894 firm-year observations between 2001 and 2009.

Findings

The study finds that the use of reinsurance in general has a negative impact on property/casualty insurers' performance. However, reinsurance obtained from affiliated firms has a positive impact on profitability, which supports the existence of internal capital markets in the insurance industry.

Research limitations/implications

The finding of study implies that reinsurance transactions are used among affiliated insurers for not only managing underwriting risk and increasing underwriting capacity but also subsidizing capital through internal capital markets. In term of limitation, due to the availability of price data, this study uses only one insurance cycle of 9 years, albeit not weakening the findings.

Practical implications

Especially for non-affiliated insurers, the finding suggests that they need to find an alternative way to transfer underwriting risk without having to use costly reinsurance.

Originality/value

This paper directly investigates the impact of reinsurance utilization on insurers' profitability and pricing.

Details

Managerial Finance, vol. 47 no. 7
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 1 February 2000

DAVID C. CROSON and HOWARD C. KUNREUTHER

This article examines how reinsurance coupled with new financial instruments can expand coverage to areas exposed to catastrophe losses from natural disasters, and…

Abstract

This article examines how reinsurance coupled with new financial instruments can expand coverage to areas exposed to catastrophe losses from natural disasters, and demonstrates how reinsurance and the catastrophe‐linked financial instruments can be combined to lower the price of protection from its current level. A simple example illustrates the relative advantages and disadvantages of pure catastrophic bonds and pure indemnity reinsurance in supporting a structure of payments contingent on certain extreme events occurring. The authors suggest ways to combine these two instruments using customized catastrophe indices to expand coverage and reduce the cost of protection. This article states six principles for designing catastrophic risk transfer systems and discusses practical issues for implementation, and then concludes with suggestions for future research.

Details

The Journal of Risk Finance, vol. 1 no. 3
Type: Research Article
ISSN: 1526-5943

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