Reinsurance and Systemic Risk: The Impact of Reinsurer Downgrading on Property–Casualty Insurers

• Author: Xiaoying Xie,Sojung Carol Park
• Published date: 01 September 2014
• DOI: http://doi.org/10.1111/jori.12045
• Date: 01 September 2014

REINSURANCE AND SYSTEMIC RISK:THE IMPACT OF

REINSURER DOWNGRADING ON PROPERTY–CASUALTY

INSURERS

Sojung Carol Park

Xiaoying Xie

ABSTRACT

This article analyzes the interconnectedness between reinsurers and U.S.

property–casualty (P/C) insurers and presents the first detailed examination

on the likely impact of major global reinsurer insolvency on the U.S. P/C

insurance industry, in order to illustrate the potential systemic risk caused by

the interconnectedness of the insurance sector through reinsurance. We find

that the likelihood of a primary insurer’s downgrade increases with its

reinsurance default risk exposure from downgraded reinsurers. Counter-

party primary insurers’ stocks also react negatively to their reinsurers’

downgrades. The negative effects also spill over to insurers that are not

directly exposed to the credit risk of downgraded reinsurers. Despite the

close interconnectedness, worst-case scenario analyses show that the

likelihood of systemic risk caused by reinsurance transactions is relatively

small for the U.S. P/C insurance industry.

INTRODUCTION

The danger of systemic risk to the financial services industry and the world economy

as a whole, as triggered by the potential failure of the reinsurance industry, has drawn

much attention from industry practitioners, regulators, and academic scholars since

the early 2000s (Swiss Re, 2003; Rossi and Lowe, 2002; The Group of Thirty, 2006).

Earlier research in general finds the risk is small and inconsequential. Such a view was

Sojung Carol Park is an Assistant Professor of Finance at the College of Business

Administration, Seoul National University, 1 Gwanak-ro, Gwanak-gu, Seoul 151-916, Korea.

Park can be contacted via e-mail: sojungpark@snu.ac.kr. Xiaoying Xie is an Associate Professor

of Finance at the Mihaylo College of Business and Economics, California State University,

Fullerton, Fullerton, CA 92834-6848. Xie can be contacted via e-mail: xxie@fullerton.edu. Sojung

C. Park acknowledges support from the Institute of Management Research at Seoul National

University, the Institute of Finance and Banking at Seoul National University, and the Research

Settlement Fund for the new faculty of SNU. Xiaoying Xie acknowledges support from the G-

CAT research fund of the Center for Insurance Studies, and a research grant from Mihaylo

College of Business and Economics of California State University, Fullerton. We are very

grateful to the two anonymous referees for their valuable comments and suggestions.

© The Journal of Risk and Insurance, 2014, Vol. 81, No. 3, 587–621

DOI: 10.1111/jori.12045

587

challenged in the wake of the recent financial crisis, as the meltdown of insurance

giant American International Group (AIG) severely deepened the crisis. As a result, a

new round of research has emerged to examine the financial stability of the insurance

industry and its potential to pose systemic risks to the whole financial system and to

national/international economies (Geneva Association, 2010; Cummins and Weiss,

2014; Grace, 2010; Bell and Keller, 2009; Acharya et al., 2009; Harrington, 2009; Billio

et al., 2012; Kessler, 2014; Chen et al., 2014). The discussion has continued and has

become increasingly important, to the degree that various regulation parties have

gotten involved in orderto try to identify systemically important financial institutions.

In 2011, the Financial Stability Board identified a set of Globally Systemically

Important Financial Institutions (Weil Financial Regulatory Reform Center, 2012).

Meanwhile, the International Association of InsuranceSupervisors (IAIS) was tasked

to develop an assessment methodology to identify Global Systemically Important

Insurers, and an initial list is expected after April 2013 (IAIS, 2012). In those

documents, reinsurance was proposed as an important factor to assess the systemic

importance of an insurer. This increasing focus of regulation on the insurance–

reinsurance industry definitely calls for in-depth academic research in the area.

The literature generally uses three primary indicators to assess the degree of systemic

risk posed by an institution/industry: size, interconnectedness, and substitutability.

It is argued that the property–casualty (P/C) insurance industry may be subject to

systemic risk because of its heavy dependence on reinsurance and the complexity of

the reinsurance market (Cummins and Weiss, 2014). As argued in Acharya et al.

(2009), “The reinsurance market increases the interconnectedness of the system

exponentially and therefore might increase the systemic risk in the overall market”

because of the “bilateral [relationship] in nature and [the lack of] adequate risk

controls due to the opacity of bilateral markets.” Despite the broad discussion on

reinsurance and systemic risk in existing literature, little empirical work has been

done to examine the actual interconnectedness of the insurance and reinsurance

systems and test how significant the risk could be. Our research intends to fill this gap

to some extent by investigating this interconnectedness through examining the

reaction of P/C insurers to reinsurer downgrading and conducting scenario analyses

to show the hypothetical impacts of major reinsurance groups’ insolvency on the U.S.

P/C insurance industry. As an addition to existing literature, this paper adopts a

more sophisticated methodology and provides more comprehensive empirical

analyses to test if reinsurers could be a significant source of systemic risk.

Reinsurance companies are at the top of the insurance sector network. The failure of

reinsurance companies may create financial instability within the broader insurance

sector, which could cause a spillover effect into the whole economy. In addition, this

risk could be aggravated if the increased default risk of primary insurers due to

the failure of reinsurers cannot be conceived of transparently in the market, as

we have seen in the recent financial crisis. In fact, to outside investors, reinsurance

arrangements between primary insurers and reinsurers often seem to be quite

complicated, given the complexity of the contract terms and the number of parties

involved in the cession and retrocession arrangements. Therefore, it is important to

understand the connectedness of the insurance and reinsurance industries and the

ability of the market to evaluate the reinsurance risk exposure of primary insurers.

588 THE JOURNAL OF RISK AND INSURANCE

In this research, we analyze the impact of reinsurance company credit rating

downgrades on counterparty primary insurance companies’ credit ratings and stock

returns, in order to illustrate the interconnectedness of the insurance sector and to

investigate whether the reinsurance credit risk information is transparently delivered

to the capital market.

Understanding the interconnectedness is an important step in the context of

evaluating the potential systemic risk caused by reinsurance companies. However,

this does not provide us information on how serious the potential problem could be.

We cannot assess systemic risk brought by reinsurers using historical data because, to

date, there has never been a major reinsurance company collapse (Swiss Re, 2003).

To get some sense of the magnitude of systemic risk, we conduct multiple scenario

analyses in which major global reinsurer(s) collapse(s).

By providing empirical evidence of interconnectedness, the market’s ability to

evaluate the risk, and the potential impact on the U.S. P/C industry caused by major

reinsurance insolvency, we hope that this article can shed light on the systemic risk

that the reinsurance sector may pose to the entire financial system and overall

economy. The remainder of the article proceeds as follows. After a discussion of the

relevant literature on insurance industry interconnectedness, we move on to discuss

the data, sample, and methodology, then present empirical results and discussion.

REINSURANCE AND INSURANCE INDUSTRY INTERCONNECTEDNESS

Reinsurance companies are essential to the global insurance industry and have

functioned smoothly in the past. However, some concerns in relation to the possibility

of systemic risk posed by reinsurance companies have been raised recently, and these

concerns can be summarized as follows. First, the top five reinsurance groups

1

provided approximately 60 percent of reinsurance worldwide in 2009 (A.M. Best

Company, 2010). The U.S. P/C insurance market also depends heavily on the top

reinsurance groups. Based on data reported to the NAIC, the top five global

reinsurance groups provide about 30 percent of unaffiliated reinsurance to U.S. P/C

insurers. Therefore, these reinsurance companies are at the top of the insurance

sector’s interconnectedness (Swiss Re, 2003; Cummins, 2007; Cummins and

Weiss, 2014). Reinsurance company failure would have a significant impact on

primary insurers because those reinsurers may no longer be able to pay the primary

insurers’ losses. Unfortunately, little is known about the pattern and degree of

damages caused by reinsurer failure on primary insurers throughout the world and,

consequently, the systemic risk to the real economy (Swiss Re, 2003).

Second, it is hard to isolate the impact of major reinsurer failure from primary insurers

and the economy due to the complexity and opacity of reinsurance. There is a serious

lack of transparency associated with the risk of reinsurance transactions due to the

international nature of reinsurance companies and a lack of standardized prudential

supervision (Cole and McCullough, 2006; Rossi and Lowe, 2002; Acharya et al., 2009).

To some extent, rating agencies may help reduce some information asymmetry and

1

Munich Re, Swiss Re, Berkshire Hathaway Reinsurance, Hannover Re, and XL Capital.

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