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Reinsurance Counterparty Relationships and Firm Performance In the U.S. Property-Liability Insurance Industry

byJ. David Cummins, Zhijian Feng, Mary A. Weiss

Prepared for: CICIRM

Kunming ChinaJuly 19, 2013

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Introduction

Financial crisis has focused attention on interconnectedness within financial services industryAcharya et al, 2010; Billio et al., 2010, Cummins and Weiss, 2011)

Reinsurance is most important form of interconnect-edness within insurance(Bell and Keller, 2009, Acharya et al, 2009, Swiss Re, 2003)

In 2010, Reinsurance Recoverable was $346.3 B

Represents 34% of liabilities and 60% of equity

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Purpose

Investigate reinsurance counterparty exposure to P&L insurance from ceding insurance

Use detailed data on reinsurance transactions from NAIC annual statement

Counterparty relationships measured in terms of

1. Percent of reinsurance premiums ceded/DPWA

2. Reinsurance recoverable/Surplus

3. Concentration ratios –

% ceded(recoverable) to top reinsurer(s);

Herfindahl indices of prem. ceded (reins. recoverable)

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Analysis Performed

Two sets of analyses:

1. Investigate determinants of reinsurance counterparty

relationships -- Types of firms having high utilization, exposure, concentration

2. Investigate relationship between reinsurance counterparty exposure and ceding insurer financial performance --

Performance includes ROA, ROE, and Efficiency Scores

.

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Contribution to the Literature

1. First study to study determinants of reinsurance counterparty relationships by ceding companies using detailed data on reinsurance transactions

2. First study to study relationship between ceding insurer financial performance and reinsurance counterparty exposure

3. First paper to use both ceded premium volume and reinsurance recoverable to measure counterparty exposure

4. Adds to recent discussions on systemic risk and interconnectedness within insurance industry (Harrington, 2009 and Geneva Association, 2010)

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Outline of Presentation

1. Hypotheses Development

2. Methodology

3. Data

4. Results

5. Conclusion

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Hypotheses: Introduction

P&L insurers internally diversity risks, but cannot fully eliminate underwriting risk (e.g., catastrophic losses).

Thus insurers transfer risks to reinsurers to stabilize earnings and expand underwriting capacity

Reinsurance is major source of interconnectedness within industry.

Ceding insurer still fully liable to policyholders for losses.

Reinsurance plays important role in solvency and reliability of insurance sector.

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Hypotheses: Determinants of Reins. Counterparty Relationships

H1: The size of an insurer is inversely related to reinsurance utilization and exposure but directly related to the degree of concentration with reinsurance counterparties.

Degree of internal risk diversificationRelative capitalization to size of risks insuredLarge firms require large capacity in reinsurers

H2: Stock insurers have lower reinsurance utilization and exposure than mutual insurers but have higher reinsurance counterparty concentration.

Access to external capital lower for mutualsMutuals more sensitive to concentrations of risk

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Hypotheses: Determinants of Reins. Counterparty Relationships I

H3: Reinsurance utilization and exposure are directly related to underwriting portfolio risk, but reinsurance counterparty concentration is inversely related to underwriting risk.

E.g., catastrophe risk

H4: Reinsurance utilization, exposure and concentration are directly related to firm leverage and investment portfolio risk such that insurers with higher leverage or higher investment portfolio risk rely more heavily on reinsurance and have lower counterparty concentration.

Need to balance leverage, underwriting and investment risk

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Hypotheses: Reinsurance Counterparty Relationships and Firm Performance

H5: Primary insurer financial performance is related to the concentration in reinsurance counterparties. The direction of the relationship is indeterminent.

More diversified reinsurance portfolios may mean better performance

Concentration may result in reduction of information asymmetries

H6: Primary insurer financial performance will be inversely affected by high reliance on one reinsurer.

Reinsurer may exercise market powerInsurance buyer reluctance if too concentrated

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Hypotheses: Reinsurance Counterparty Relationships and Firm Performance II

H7: Utilization, exposure, and concentration of reinsurance with unaffiliated reinsurers will have a stronger adverse effect on ceding company performance than affiliated reinsurance transactions.

Information asymmetries should be lower among affiliatedMore concern about adverse selection with unaffiliated

H8: Utilization, exposure, and concentration of foreign reinsurance are expected to have a significant effect on ceding insurer performance in comparison with domestic transactions. Direction of relationship not determined.

Solvency and service quality harder to monitor for foreignBut collateralization of reinsurance liabilities

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Methodology

Outline of methodology

1. Measures of Reinsurance Utilization, Exposure, and Concentration

2. Firm Performance Measures

3. Specification of Regression Models

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Methodology: Measures of Reinsurance Counterparty Relationships

Utilization, and Exposure, and Concentration

Utilization: the ratio of reinsurance premiums ceded to direct premium written plus reinsurance assumed --RPC_DPWA

Exposure: the ratio of reinsurance recoverable to total policyholder surplus – RR/PHS

Concentration: Measured both with premium ceded and reinsurance recoverable—The percentage of ceded premium (recoverable) to the

leading reinsurance counterparty(ies) --RPC_TOP_1 (RR_TOP_1)

Herfindahl Indices – HHI_RPC (HHI_RR)

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Methodology: Measures of Reinsurance Counterparty Relationships II

Utilization, Exposure and Concentration (Cont’d)

Subcategories of Concentration based on Reins. Prem. Ceded (RPC) and Reins. Recoverable (RR)

Foreign reinsurance

HHI_RPC_Foreign and %RPC_ForeignHHI_RR_Foreign and %RR_Foreign

Unaffiliated reinsurance

HHI_RPC_Unaffiliated and %RPC_UnaffiliatedHHI_RR_Unaffiliated and %RR_Unaffiliated

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Methodology: Measures of Firm Performance

Traditional: ROA, ROE

Efficiency: Cost, Revenue, ProfitEfficiency estimated with Data Envelopment

Analysis (DEA): a non-parametric technique that measures the performance of each firm in an industry relative to “best practice” efficient frontiers consisting of the dominant firms in the industry.

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Methodology: Measures of Firm Performance II

DEA has several desirable statistical properties:

1. Equivalent to maximum likelihood estimation

2. DEA estimators are consistent and converge faster

3. DEA estimators unbiased if no underlying technology

4. Can be interpreted as nonparametric stochastic frontier estimation methodology

5. Two stage approach yields consistent estimates

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Methodology: Measures of Firm Performance III

Unit of analysis at company (not group level)

Cost, Revenue and Profit Efficiency estimated for all U.S. property-liability insurers with valid data for sample period 1993 to 2009.

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Methodology: Measures of Firm Performance IV

Input Estimation

Input Input Quantity Input Price

Administrative Labor Administrative Expense/ Based on (deflated) average weekly wages inAdministrative Price home state for property-liability insurers

Agent Labor Agent Expense/ Based on (deflated) premium-weighted average Agent Price weekly wages for insurance agencies

Materials Materials Expense/ Based on (deflated) weighted average of national Materials Price price indices for materials and service items

from NAIC expense exhibit.

Financial Capital Average deflated surplus Cost of equity capital based on size-adjustedCapital Asset Pricing Model (CAPM)

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Methodology: Measures of Firm Performance VOutput Estimation

Output Output Quantity Output Price

Risk Pooling by Line PV(Real Loss Incurredi) [Premiumi - PV(Loss Incurredi)/PV(Loss Incurredi)

personal short tail personal long tail comm'l short tail comm'l long tail

Intermediation Average Real Invested Weighted average of expected return on bondsAssets and expected return on firm's equities

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Methodology: Regression Model for Determinants

Determinants of Reinsurance Relationships

yit = Measures of reinsurance counterparty utilization, exposure, and concentration

TS=fixed year effectsCS=fixed cross-section effects

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1 1 1

qn m

it j ijt k ik t p ipt itj t p

y FirmChar TS CS

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Methodology: Regression Model for Determinants II

Measuring Firm-Specific CharacteristicsFirm Size Organizational Form (Stock=1)Underwriting Risk: Catastrophe Exposure, Investment portfolio risk: %STOCK, %MBS Leverage: Premium/Surplus

Other Control Variables:Group AffiliationGeographic Concentration (HHI)Lines of business controls (% premiums in line)Line of Business Concentration (HHI)

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Methodology: Regression Model for Determinants III

Two-Stage-Least-Squares (2SLS) used to estimate regression equation:

Premium/Surplus and Catastrophe Exposure --endogenous

Instrumental Variables:

line of business ratios

current and 1 year lagged interest rates

market rate of return

time trend

Wald test to determine instrument relevance and Hansen’s J test to check validity of instruments.

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Methodology: Regression Model for Performance

Relationship between performance and reinsurance utilization, exposure and concentration:

•yit = measures of performance

• Cost Efficiency (CE),

Rev. Efficiency (RE),

Profit Efficiency (PE),

ROA, and ROE

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1 1 1 1

ReQn K P

it j ijt k ikt p ipt q iqt itj k p q

y insurance CtrlVar TS CS

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Methodology: Regression Model for Performance II

• Counterparty Relationships:• RPC/DPWA, %RPC_Unaffiliated, %RPC_Foreign• RPC_TOP_1, HHI_RPC, HHI_RPC_Unaffiliated,

HHI_RPC_Foreign

• RR/PHS, %RR_Unaffiliated, %RR_Foreign• RR_TOP_1, HHI_RR, HHI_RR_Unaffiliated• HHI_RR_Foreign,

Control Variables:

Firm Size, Stock Indicator, Premium/Surplus, Group

Indicator, Lines of Business %, %STOCK, %MBS,

HHI_Geographic, and HHI_Line of Business

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Data and Sample

Data are taken from NAIC database for U.S. P/L insurers from 1993 to 2009.

Eliminate data for risk retention groups, extremely small firms, firms with negative premium, policyholder surplus and other outliers

Eliminate negative reinsurance transaction cessionsFinal sample consists of 21422 firm-year observations for the

analysis based on reinsurance premium ceded, and of 21279 observations for the analysis based on reinsurance recoverable

Other data sources include Best’s A&A, Ibbotson Valuation Yearbook, U.S. Bureau of Labor Statistics, and FRED database, for efficiency estimation

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Empirical Results: Determinants of Reinsurance

Two-Stage Least SquaresDeterminants of Reinsurance Utilization, Exposure, and Concentration

Utilization Exposure ConcentrationDependent Variable RPC/DPWA RR/PHS HHI_RPC RPC_TOP_1 HHI_RR RR_TOP_1

Firm Size -0.010 *** -0.086 *** -0.025 *** -0.037 *** -0.024 *** -0.054 ***

Stock -0.120 ** -0.163 *** 0.114 ** 0.135 ** 0.095 * 0.112 *

Catastrophe Exposure 0.013 *** 0.015 * -0.017 *** -0.032 * -0.017 *** -0.008 *

%Stock 0.043 *** 0.083 * -0.024 *** -0.033 -0.115 -0.077 *

%MBS 0.003 *** 0.004 * -0.049 ** -0.011 -0.012 -0.006 *

Premium/Surplus 0.006 *** 0.003 * 0.007 * 0.004 * 0.020 ** 0.009 ***

N 21422 21279 21422 21422 21279 21279Adjusted R-squared 0.196 0.231 0.18 0.153 0.242 0.235

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Empirical Results: Determinants of Reinsurance II

Results from Control Variables:

group indicator:

positive and significant in all models

Line of business HHI:

sig. positive for utilization and exposure

sig. negative for concentration

Line of business mix

Comm’l LT and Personal LT positively related to utilization and exposure but negatively related to concentration

Comm’l ST not significant

Geographic HHI

not significant

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Empirical Results:Performance and Reinsurance (RPC)

Dependent Variable CE RE PE ROA ROE

Utilization (RPC/DPWA) 0.117 ** 0.185 *** 0.038 ** 0.243 ** 0.210 ***

Concentration (RPC_Top 1) -0.165 *** -0.183 *** -0.013 * -0.152 * -0.171 **

Concentration (HHI_RPC) -0.013 * -0.003 * -0.021 * -0.026 * -0.017 *

HHI_RPC_Unaffiliated -0.015 ** -0.018 ** -0.031 *** -0.015 ** -0.014 **

HHI_RPC_Foreign 0.021 *** 0.033 * 0.026 0.028 * 0.026 *

%RPC Unaffiliated -0.122 * -0.134 ** -0.113 -0.138 ** -0.133 **

%RPC_Foreign 0.017 *** 0.024 *** 0.021 0.003 *** 0.005 ***

%RPC_Foreign_Unaffiliated -0.007 ** -0.005 -0.003 -0.032 -0.033

N 21422 21422 21422 21422 21422Adjusted R-squared 0.233 0.228 0.215 0.227 0.208

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Empirical Results:Performance and Reinsurance (RR)

Dependent Variable CE RE PE ROA ROE

Exposure (RR/PHS) 0.202 ** 0.275 *** 0.225 *** 0.185 ** 0.120 ***

Concentration (RR_Top 1) -0.162 ** -0.155 * -0.082 * -0.063 ** -0.075 **

Concentration (HHI_RR) -0.006 ** -0.005 * -0.006 * -0.014 * -0.017 **

HHI_RR_Unaffiliated -0.018 ** -0.023 ** -0.012 ** -0.006 * -0.011 *

HHI_RR_Foreign 0.027 * 0.023 * 0.021 0.024 0.021 *

%RR Unaffiliated -0.021 * -0.012 * -0.023 -0.036 ** -0.125 **

%RR_Foreign 0.025 *** 0.028 *** 0.022 0.005 *** 0.001 ***

%RR_Foreign_Unaffiliated -0.012 ** -0.001 -0.028 -0.012 -0.010

N 21279 21279 21279 21279 21279Adjusted R-squared 0.213 0.207 0.176 0.174 0.168

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Empirical Results:Performance and Reinsurance

Control Variable Results:

Premium/Surplus < 0

STOCK Indicator > 0

Group Indicator > 0

%MBS < 0

Line of Business HHI > 0

Firm Size > 0

Lines of Business Proportions:

Personal LT < 0

Commercial LT > 0

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Robustness tests

1. Used group level analysis

2. Durbin-Wu-Hausman tests conducted for reinsurance variables in the performance regressions

3. Finer measures of reinsurance utilization, exposure, and concentration used in the performance regressions.

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Determinants of Reinsurance Utilization, Exposure and Concentration: Group Level Analysis I

Two-Stage Least SquaresDeterminants of Reinsurance Utilization, Exposure, and Concentration: Group Results

Utilization Exposure ConcentrationDependent Variable RPC/DPWA RR/PHS HHI_RPC RPC_TOP_1 HHI_RR RR_TOP_1

Firm Size -0.031 ** -0.028 *** -0.045 *** -0.058 ** -0.024 *** -0.017 ***

Stock -0.127 ** -0.168 ** 0.106 * 0.130 ** 0.121 ** 0.200 **

Catastrophe Exposure 0.020 ** 0.017 * -0.017 ** -0.035 * -0.017 *** -0.036 *

%Stock 0.021 * 0.021 * -0.337 * -0.043 * -0.337 * -0.043 *

%MBS 0.001 * 0.001 * -0.019 * -0.008 * -0.019 * -0.008 *

Premium/Surplus 0.006 *** 0.006 ** 0.007 * 0.003 * 0.007 * 0.003 *

N 15428 15428 15428 15428 15428 15428Adjusted R-squared 0.160 0.165 0.117 0.165 0.101 0.105

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Empirical Results:Performance and Reinsurance (RPC) - Group Results II

Dependent Variable CE RE PE ROA ROE

Utilization (RPC/DPWA) 0.301 *** 0.197 *** 0.187 * 0.217 ** 0.224 ***

Concentration (RPC_Top 1) -0.188 ** -0.191 * -0.002 * -0.153 * -0.151 *

Concentration (HHI_RPC) -0.003 * -0.003 ** -0.006 * -0.003 * -0.001 *

HHI_RPC_Foreign 0.022 * 0.021 * 0.017 0.025 * 0.023 *

HHI_RPC_Domestic -0.325 * -0.398 ** -0.272 -0.112 * -0.154 *

%RPC Foreign 0.042 ** 0.048 ** 0.013 0.033 ** 0.041 ***

N 15428 15428 15428 15428 15428Adjusted R-squared 0.112 0.128 0.126 0.102 0.104

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Finer Measures of Reinsurance Variables

Dependent Variable CE RE PE ROA ROE

Exposure (RR/PHS) 0.114 ** 0.187 *** 0.039 ** 0.247 ** 0.215 ***

Concentration (RR_Top 1) -0.164 *** -0.182 *** -0.016 ** -0.152 * -0.071 *

Concentration (HHI_RR) -0.014 * -0.005 * -0.044 * -0.024 * -0.011 **

HHI_RPC_Domestic_Unaffiliated -0.026 *** -0.022 *** -0.018 * -0.007 *** -0.013 ***

HHI_RPC_Domestic_Affiliated -0.024 -0.017 -0.003 -0.019 -0.016

HHI_RPC_Foreign_Unaffiliated 0.010 ** 0.013 ** 0.018 * 0.011 ** 0.012 **

HHI_RPC_Foreign_Affiliated 0.002 0.004 0.028 0.006 0.008 *

%RPC_Domestic_Unaffiliated -0.013 * -0.021 * -0.022 * -0.014 * -0.020 *

%RPC_Foreign_Unaffiliated -0.224 * -0.075 * -0.058 -0.324 -0.135

%RPC_Foreign_Affiliated 0.023 *** 0.017 * 0.055 0.119 * 0.083 *

N 21422 21422 21422 21422 21422Adjusted R-squared 0.23 0.214 0.216 0.187 0.139

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Conclusion I

Reinsurance is primary source of interconnectedness in the insurance industry, but also traditional and efficient risk management tool.

Analysis performed:

1.Identify firm characteristics that lead to a higher level of

utilization, exposure and concentration in reinsurance

counterparties.

2.Analyze the relationship between interconnectedness

and primary insurer performance.

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Conclusion II

Determinants of Reinsurance:

1. Large insurers purchase less reinsurance but have

higher concentration in reinsurance counterparties.

2. Stock insurers have lower reinsurance usage but higher

concentration in reinsurance counterparties.

3. Insurers with greater relative underwriting risk purchase

more reinsurance but are less concentrated in

reinsurance counterparties.

4. Insurers with higher asset portfolio risk use more

reinsurance from a more diversified set of reinsurers.

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Conclusion IIIPerformance and Reinsurance:1. Reinsurance utilization is positively related to all performance measures.

2. Ceding insurer performance is adversely related to concentration in reinsurance counterparties.

3. Higher concentration in unaffiliated reinsurance is adversely related to performance.

4. Concentration in foreign reinsurers is positively related to performance.

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Thank You!