The Sensitivity of Reinsurance Demand to Counterparty Risk: Evidence From the U.S. Property–Liability Insurance Industry

• DOI: http://doi.org/10.1111/jori.12244
• Author: Pinghai Rui,Sojung Carol Park,Xiaoying Xie
• Date: 01 December 2019
• Published date: 01 December 2019

THE SENSITIVITY OF REINSURANCE DEMAND TO

COUNTERPARTY RISK:EVIDENCE FROM THE U.S.

PROPERTY–LIABILITY INSURANCE INDUSTRY

Sojung Carol Park

Xiaoying Xie

Pinghai Rui

ABSTRACT

This article investigates market discipline in the reinsurance market by

examining the sensitivity of reinsurance demand to reinsurer counterparty

risk for a sample of U.S. property–liability insurance companies. Using

the financial strength rating of reinsurers as a proxy for reinsurance

counterparty risk, we find evidence of market discipline that reinsurance

demand is sensitive to counterparty risk. Specifically, reinsurance demand

reacts negatively to reinsurer rating downgrades, with the reduction being

the largest when a “weak” reinsurer gets “weaker,” followed by a reinsurer

being downgraded below a benchmark rating. The sensitivity is higher for

authorized reinsurance than for unauthorized reinsurance. Reinsurance

demand sensitivity to counterparty risk is found to be lower for ceding

insurers with higher leverage. Ceding insurers with high reinsurer

sustainability are less sensitive to noncritical rating downgrades of

reinsurers. Additionally, reinsurance demand is found to be less sensitive

to reinsurer upgrading than to reinsurer downgrading.

Sojung Carol Park is an Associate Professor at Seoul National University Graduate School

of Business and the Institute for Industrial Systems Innovation, Seoul National

University. Park can be contacted via e-mail: sojungpark@snu.ac.kr. Xiaoying Xie is a

Professor of Finance, Mihaylo College of Business and Economics, California State

University, Fullerton, 800 North State College Blvd., Fullerton, CA 92831, USA. Xie can be

contacted via e-mail: xxie@fullerton.edu. Pinghai Rui is a graduate student at College of

Business Administration, Seoul National University. Rui can be contacted via e-mail:

ruipinghai@snu.ac.kr. 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. Xiaoying Xie acknowledges the research grant support from

the Center for Insurance Studies, Mihaylo College of Business and Economics of

California State University, Fullerton.

2018 The Journal of Risk and Insurance. Vol. 9999, No. 9999, 1–32 (2018).

DOI: 10.1111/jori.12244

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Vol. 86, No. 4, 915–946 (2019).

INTRODUCTION

Reinsurance plays a pivotal economic role in risk management. With the ability to

diversify risks both nationally and globally, reinsurance is an important tool for

primary insurance companies in managing underwriting risks, reducing the risk

of insolvency, satisfying stringent regulatory requirements, and dealing with

uncertainties caused by regulatory changes or catastrophic losses. Also, primary

insurance companies can improve their balance sheets by using reinsurance. By

transferring or ceding risks to reinsurers, a ceding insurer may take credit (e.g.,

reducing loss reserves and unearned premium reserves) in its financial statements,

which helps provide surplus relief and increase its underwriting capacity. The use of

reinsurance, however, also creates a new type of risk for ceding insurers: reinsurer

counterparty risk.

Prior to 2011, a ceding reinsurer was allowed to take credit for reinsurance only when

its counterparty reinsurer was authorized

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or, if unauthorized, by posting full

collateral for the reinsurance transaction. One important rationale for this collateral

requirement was reinsurer counterparty risk. However, the full collateral require-

ment, in some sense, disregarded the ceding insurers’ ability to self-manage

reinsurance credit risk and offered little incentive for primary insurers to distinguish

between reinsurers with stronger financial strength and those with weaker financial

strength. This requirement was therefore considered to be excessive and may distort

the reinsurance market.

In order to solvethis problem, regulatory changes have occurredregarding reinsurance

collateralrequirements. The National Association of InsuranceCommissioners (NAIC)

proposed a Reinsurance Regulatory Modernization Framework Proposal in 2008.

The federal government alsoenacted a reform act. On July 21, 2010, the U.S. Congress

passed the Nonadmitted and Reinsurance Reform Act, which became effective on

July 21, 2011. Many states began adopting the new reinsurance modernization

framework and relaxed the collateral requirement for unauthorized reinsurance

transactions.

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With the changes in the regulatory environment, it is important to

understandthe behavior of ceding insurers in the reinsurancemarket. In this article, we

test reinsurance demandsensitivity to reinsurer credit risk change in order to examine

whether ceding insurersare able to control counterparty reinsurance risk, andwe also

investigatewhether the collateral requirement indeeddistorted demand sensitivity for

unauthorized reinsurance transactions.

Traditionally, research on reinsurance has focused on dealing with asymmetric

information in the insurer–reinsurer relationship (e.g., Doherty and Smetters, 2005;

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Reinsurers that register in a state, under state regulatory supervision, and satisfy certain

conditions are classified as authorized reinsurers.

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For example, in New York, from January 1, 2011, Regulation 20 (11 NYCRR 12) provided a

means for ceding insurers to receive credit for unauthorized reinsurance transactions with less

than 100 percent of collateral. Depending on the financial strength of reinsurers and various

factors such as business practices and other relevant information, the superintendent can

decide the collateral amount required, which could even be zero. In New York, Hannover Re

became the first reinsurer to qualify to post 20 percent loss reserves instead of 100 percent.

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Garven, Hilliard, and Grace, 2014) and on exploring the optimal design for

reinsurance contracts (e.g., Tan and Weng, 2012; Cai et al., 2013). More recently, there

has been more empirical research on the factors determining the demand for

reinsurance by ceding insurers (e.g., Cole and McCullough, 2006; Lin, Yu, and

Peterson, 2015). Additionally, the most recent financial crisis of 2007–2009 has thrust

the reinsurance industry into the public eye both for its close interconnectedness with

the primary insurance industry and for the possibility of creating systemic risks for

the economy (Cummins and Weiss, 2014; Park and Xie, 2014; Weißand M€

uhlnickel,

2014). Therefore, reinsurer risk and financial solvency has become an important

concern for regulators, ceding insurers, and researchers. Ceding insurers may take

“credit” for their reinsurance transactions, but for regulators, that credit for

reinsurance only makes sense when reinsurers are able to fulfill their obligations.

Also, it is argued that even in the absence of regulations, ceding insurers should still

have concerns regarding reinsurance credit quality. Poor reinsurance contracting

may adversely affect the default probability of ceding insurers and lower their

financial strength ratings (Park and Xie, 2014), which may ultimately lower the

revenue of ceding insurers, as insurance buyers may opt to “pay for quality”

(Cummins and Danzon, 1997).

Despite the credit risk posed by reinsurance, little empirical research has been done to

examine how credit risk from reinsurers may affect ceding insurers’ behaviors. Park

and Xie (2014) analyze the impact of credit risk from reinsurers on ceding insurers’

financial strength and stock performance and find both that ceding insurers are more

likely to be downgraded, when their contracting reinsurers are downgraded and that

ceding insurers’ stocks also react negatively to their reinsurers’ downgrades. That

article suggests that counterparty risk from reinsurers is important to ceding insurers

and should be carefully managed.

The objective of this article is to examine the relationship between reinsurance demand

and the credit risk change of reinsurers by using the U.S. property–liability insurance

industry as an experiment. In particular, we investigate the sensitivity of reinsurance

demand to the downgrading of reinsurers and the likelihood that ceding insurers will

revise a contract relationship with a reinsurance partner whose financial strength

changes. We hypothesize that if market discipline exists, a ceding insurer will recognize

the impact of reinsurers’ credit risk change and adjust its contracts accordingly when a

reinsurer’s rating changes. In particular, ceding insurers would adjust trading terms with

the downgraded counterparty reinsurers through changes in both price and quantity of

reinsurance purchased, or, in extreme cases, terminate the relationship with the

downgraded reinsurers. If this is the case, heavy regulation on reinsurance, such as 100

percent collateral requirements on certain reinsurance transactions, may not be

justifiable. On the other hand, if ceding insurers fail to adjust their reinsurance position

in accordance with reinsurers’ credit risks, it may suggest that such insurers simply use

reinsurance for regulatory incentives and have neglected credit quality. Solvency risk to

ceding insurers may therefore increase when the reinsurer downgrades, and such risk

has to be taken seriously by the insurers, the market, and the regulators.

This article contributesto the literature in three main ways. First, it enriches the existing

literature on counterparty riskin the financial services industry (Jarrow and Yu, 2001;

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