Interactions Between Risk Taking, Capital, and Reinsurance for Property–Liability Insurance Firms

• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/jori.12080
• Date: 01 December 2016

INTERACTIONS BETWEEN RISK TAKING,CAPITAL,AND

REINSURANCE FOR PROPERTY–LIABILITY INSURANCE FIRMS

Selim Mankaı

¨

Aymen Belgacem

ABSTRACT

Financial theory has long recognized the structural relationship between

capital and risk. This article posits reinsurance usage as a new endogenous

decision variable and analyzes its effect on this decision mix from a sample

of U.S. property–liability insurance firms. Empirical results obtained from a

simultaneous equation model confirm the mutual interactions among

capital, reinsurance and risk taking. Risk taking is positively related to

capital, which highlights the effectiveness of regulatory mechanisms and the

relevance of the capital buffer hypothesis. Reinsurance is negatively

associated with capital, for which it displays a substitutive effect. These

results seem to vary with the insurers’ level of capitalization, affiliation with

a group, size, and organizational form. Unlike other decision variables, the

capital ratio is adjusted to its target level.

INTRODUCTION

To reduce the likelihood of their failure, insurance firms have always been subject to

various constraints related to risk taking and capital holding. In this respect, capital

adjustments are generally made through earnings retention or new shares issuance.

Hoerger, Sloan, and Hassan (1990) and Garven and Lamm-Tennant (2003) demons-

trate that reinsurance, which involves ceding part of the assumed underwriting risk,

may affect these decisions by reducing loss volatility and acting as contingent capital.

More recently, the role of reinsurance has become even more important in view of

regulatory developments that are more amenable to defining capital requirements in

terms of some of its qualitative aspects (Eling and Holzm€

uller, 2008; Scordis and

Steinorth, 2012). Understanding the relationship between capital, risk, and

reinsurance is of great significance for regulators, who must craft prudential rules

Selim Mankaı

¨is at the IPAG Business School. Aymen Belgacem is at the University of Orl

eans,

Technology Institute of Bourges, Laboratoire d’Economie d’Orl

eans. Selim Mankaı

¨can be

contacted via e-mail: selim.mankai@udamail.fr.

© 2015 The Journal of Risk and Insurance. Vol. 83, No. 4, 1007–1043 (2016).

DOI: 10.1111/jori.12080

1007

to regulate insurers’ solvency.

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Shareholders are also concerned with the possible

transmission of shocks to capital resulting from unanticipated losses. Negative shocks

often entail forced sales of assets, which adversely affect the firm value.

Among the relationships between the three decision variables considered in this

article, those between capital and risk are by far the most discussed in the literature.

Several hypotheses related to moral hazard, agency costs, and regulatory pressures

have been posited to explain their mutual interactions. The first hypothesis, based on

agency costs and buffer capital theory, predicts a positive relationship between

capital and risk. An alternative hypothesis, based on information asymmetry,

predicts a negative relationship. The conflicting predictions of these two hypotheses

paved the way for an active empirical research. Shrieves and Dahl (1992) were the first

to examine this relationship for U.S. banks. In a subsequent article, Cummins and

Sommer (1996) investigate the issue for nonlife insurance firms and provide empirical

support for a positive relationship between capital and risk. Baranoff and Sager (2002)

empirically explore these interactions in the case of life insurance, finding a positive

(negative) relationship between capital and asset (liability) risk. Shim (2010) also

confirms the positive relationship between these variables.

While the association between capital and risk has been extensively studied in the

literature, few articles to date have explored the relationship between risk and

reinsurance usage (e.g., Cole et al., 2011), and even fewer, the joint interactions

between the three decision variables. Reinsurance mitigates underwriting and

solvency risks and enables insurers to increase their capacity to underwrite new

business. There are several reasons to believe that reinsurance is endogenously

influenced by the choice of capital and risk, and vice versa. In this respect, MacMinn

(1987) and Plantin (2006) find that the reinsurance ratio is determined together with

the capital structure. Dionne and Triki (2004) document a strong positive relationship

between leverage as a subscription risk indicator and reinsurance demand. In the

same vein, Shiu (2011) focuses on the endogenous nature of reinsurance and finds that

it is positively related to leverage, and vice versa. All these results support the

hypothesis of interdependence between reinsurance, capital, and risk.

This study analyzes capitalization policy and its relationship with risk taking and

reinsurance usage. More specifically, we aim to determine the nature of adjustments

between these decisions and how they move to their target levels. The contribution of

this article to the existing literature is twofold. First, we attempt to fill the gap in the

literature by examining interactions among these three decision variables instead of

studying them in pairs. We believe that much is to be gained through a joint analysis

acknowledging the simultaneity associated with decisions made in this regard. The

second contribution is an extensive empirical analysis of the interactions following

1

The theoretical literature often develops conflicting arguments about the effects of regulatory

pressure (Scannella, 2012). Strict regulation may create distortions in the operations of solvent

firms. By contrast, permissive regulations may lead to high risk exposure, threatening the

creditworthiness of insurers. This situation frequently implies a slowdown in innovation,

inefficient investment strategies, or passive capital accumulation, and to encourage good risk

management practices.

1008 THE JOURNAL OF RISK AND INSURANCE

several factors, such as the level of regulatory pressure, group affiliation, firm size,

and organizational form. We show that capital, risk, and reinsurance interact in both

directions and vary according to the transversal factors. We also provide empirical

evidence that the capital ratio moves slowly toward a target level.

This article is organized as follows. The second section sketches the theoretical

underpinnings of the interactions between risk taking, capitalization, and reinsurance

and develops a set of hypotheses. The third section identifies and discusses the main

determinants of each decision. The fourth section presents the econometric model and

estimation technique. The fifth section describes the data set and provides summary

statistics. The sixth section reports and discusses empirical results and provides some

robustness checks. The seventh section provides concluding remarks.

THEORETICAL BACKGROUND AND RESEARCH HYPOTHESIS

In this section, we briefly outline the theoretical literature that highlights the

interactions between capital, reinsurance usage, and risk taking and we posit our

hypotheses.

Interactions Between Capital and Risk

Interactions between capital and risk have been the focus of active research,

particularly in the banking sector. Since its introduction in 1994, the risk-based capital

(RBC) system appears to have steadily reinforced the interdependence between these

two decisions for insurance firms. Several theoretical arguments related to agency

costs, moral hazard, and regulatory pressures have been proposed to explain such

interactions.

The literature makes contradictory predictions regarding the nature of such

interactions. The first hypothesis refers to insurers’ incentives to exploit guaranty

funds, which provide last-resort protection when insurers are unable to fulfill their

contractual commitments. Failure costs are borne by all guaranty fund members.

When members’ contribution to the fund are not correlated with actual risk, that is,

when premiums are flat fee rather than risk based, adverse incentives can result for

insurers to increase risk and reduce capital (Cummins, 1988). However, the

importance of this hypothesis is tempered by the fact that the coverage of the

guaranty fund is less complete than in the banking sector and by the growing

effectiveness of supervisory mechanisms and market discipline (Cheng and Weiss,

2012). Therefore, the incentive to take excessive risk for nonlife insurers is restricted.

Another explanation for a negative relationship between capital and risk for U.S.

insurers may be due to flaws in the RBC formula. Cheng and Weiss (2012) argue that

some risks are overweighed, while others are underweighted. This discrepancy

encourages insurers to rearrange their portfolios by choosing assets or lines of

business with low weights. Thus, insurer aggregate risk may increase while capital

requirements decrease, resulting in a negative relationship.

The second hypothesis suggests a positive relationship between these two variables.

According to the capital buffer theory, insurers hold excess capital above the

regulatory minimum as a guaranty against unanticipated extreme losses and to avoid

INTERACTIONS BETWEEN RISK TAKING,CAPITAL,AND REINSURANCE 1009