Reinsurance and its Resilience in the Face of Financial Crisis —Evidence from U.S. Property and Liability Insurance Market Shuang Yang Department of Risk, Insurance and Healthcare Management Fox School of Business, Temple University 18th APRIA Annual Conference Moscow State University, Moscow Hello everyone, today my presentation is about reinsurance resilience …

Outline of Presentation Motivation and Research Question Literature Review Hypothesis Development Methodology Data and Sample Empirical Results Conclusion This is the outline. My presentation will include seven parts, starting with motivation and research question

Motivation and Research Question Background Reinsurers are indispensable to the global insurance industry and have functioned quite smoothly in the past decades Reinsurers’ function Risk transfer Income smoothing Expand underwriting capacity Limit catastrophic losses Provide underwriting assistance and product expertise Financial crisis of 2008 has drawn unprecedented attention to the stability of insurance sector including reinsurance The motivation for this paper originates from the recent global financial crisis. During which the market went through some difficulties: asset price volatility increases, liquidity quickly dries up and economic activity depresses The goal is to analyze in such a difficult time, how reinsurers react and examine to what extent reinsurers’ traditional function holds in the face of financial crisis, when uncertain happens. Whether these traditional function still holds in financial crisis periods.

Motivation and Research Question Why believe reinsurers are resilient? Reinsurance failures only account for 3.6% of triggering events for P-C insurers impairment and only 1.9% on life side. (A.M. Best, 2011) Reinsurers are in a better position to mitigate volatility and less vulnerable to external shocks Only extreme insurance catastrophic loss will trigger a major problem to a reinsurer, not fundamental economic situations, as the loss is triggered more by accident than by human behaviors … In this paper, I tend to believe that reinsurers are resilient because of the following reasons better risk management technique, globalized portfolio which give them adv over insurers Reinsurers won't follow financial crisis as what banks and investment would do as a result of an economic down turn

Our Research How to define reinsurance resilience? In finance context, resilience refers to the ability to continue to function at the same level after big outer shock or part of its components stop working(Farlex Financial Dictionary) Reinsurers’ ability to help insurers recover from unexpected shocks and maintain their overall financial strengthens How to measure reinsurance resilience? Through the impact of reinsurance transaction on insurers’ performance Use Best’s Key Rating score as an indicator to demonstrate insurers’ overall financial strengthen (Park and Xie 2011) This research question is converted to: the degree of resilience is measured in terms of the how helpful reinsurance is in helping maintain insurers’ rating after financial crisis took place Farlex Financial Dictionary is one of the main sources of financial dictionary by Campbell R. Harvey, renowned finance expert and J. Paul Sticht, professor of International Business at Duke University.

Our Research Two measurements of reinsurance transaction (Cummins, Feng and Weiss, 2012) Reinsurance Utilization -- how much reinsurance is used? the ratio of reinsurance premiums ceded to the sum of direct premiums written and reinsurance assumed Reinsurance Exposure -- how much an insurer’s financial statements are exposed to defaults by reinsurance counterparties? the ratio of reinsurance recoverables to policyholders’ surplus, where recoverables are the amounts owed by reinsurers to ceding insurers for paid and unpaid losses Next question is how we measure reinsurance transaction, or the interconnectedness between insurers and reinsurer. Here we follow the methodology in literature and adopt two major measurements for reinsurance interconnectedness.

Hypothesis Hypothesis: Reinsurance utilization and exposure both has an impact on an insurer’s rating grade H1: Insurers’ Best rating grade is positively related to its reinsurance utilization, since ceding insurance business to reinsurer would contribute to its own stability H2: Insurers’ Best rating grade is inversely related to its reinsurance exposure, since more exposure to its counterparty reinsurer would increase uncertainty which is unfavorable, especially during a period of financial crisis

Data and Sample Firm level data is taken from NAIC database for U.S. P/L insurers from 2009 to 2011 Insurers’ rating data is taken from Best’s Key Rating data, from 2009 to 2011 We eliminate firms with negative total asset, reinsurance utilization, or exposure Also eliminate firms with a missing rating score, with a label “NR” according to A.M. Best Rating criteria. Final sample consists of 4178 insurer-year observations

Statistics on Insurers’ rating score Best’s Rating Score Frequency A++ 13 167 A+ 12 584 A 11 1660 A- 10 1034 B++ 9 301 B+ 8 187 B 7 113 B- 6 34 C++ 5 24 C+ 4 20 C 3 C- 2 15 D 1 18 E, F Distribution of Insurers’ Rating Score Figure 1 describes the distribution of insurers’ Best’s rating grades. From this figure, we can observe the distribution a negative skewed normal distribution, where the peak is at 11, meaning insurers with an A rating is the most frequently observed Note on Best’s rating scale: A++, A+: Superior; A, A-: Excellent; B++, B+: Good. And ten vulnerable ratings for companies: B, B-: Fair; C++, C+: Marginal; C, C-: Weak; D: Poor; E: Under Regulatory Supervision; F: In Liquidation To construct dependent variable: insurers’ Best Rating grade is converted to a series of 14 ordered numbers, from 0 to 13

Methodology Score=13 if Rating=A++. Ordered Logistic Model: Define: Score=0 if Rating=E, F; Score=1 if Rating= D; … Score=13 if Rating=A++. Rating is a latent variable is a vector of all independent variables, including Reins Uti, Reins Exp, and Xl (.) is the cumulative distribution function of logistic distribution for residuals

Methodology Main Explanatory variables: Reinsurance utilization Reinsurance exposure Xl is a vector of firm-specific variables Firm size: Ln(Total Asset) Firm experience: Firm Age Leverage: Net premiums written divided by policyholders’ surplus Catastrophe risk exposure: Direct premiums written in homeowners lines in catastrophic prone states to total premiums written Combined ratio: Loss ratio and expense ratio Aggregate Capital: Sum of underwriting income, investment income, other income and other gains in surplus and new capital paid in minus dividends Other Control Variables in Xl:Group Membership, Distribution System, Organizational Form including coastal states and earthquake line in AL,FL, MS, SC, or TX A dummy variable equal to one if the insurer is a stock company and zero otherwise A dummy variable equal to one if the insurers is single unaffiliated company and zero otherwise A dummy variable equals to one if the insurer is a direct writer and zero otherwise

Summary Statistics Variables Mean STD Min Max Rating Score 10.354 1.755 13 Reinsurance Utilization 0.413 0.295 1 Reinsurance Exposure 0.103 0.464 22.8 Leverage 0.85 0.651 -0.7 5.39 Firm Size 18.85 1.782 14.4 25.5 Firm Age 50.578 41.365 217 Combined Ratio 99.058 28.12 -99.9 198.2 Aggregate Capital 60.858 758.641 -4281.1 41687.94 Catastrophic Risk Exposure 0.163 0.285 -4.5 1.11 Organization Dummy 0.76 0.427 Group Membership Dummy 0.238 0.426 Market Type Dummy 0.37

Empirical Results Variables Definition Estimates Reinsurance Utilization Reinsurance premium ceded divided by direct premium written plus reinsurance premiums assumed 1.0833*** Reinsurance Exposure Reinsurance recoverable divided by policyholders’ surplus net premium written divided by policyholders’ surplus -0.1271** Leverage Net premiums written divided by policyholders’ surplus -0.8779*** Firm Size Ln (Total Asset) 0.5335*** Firm Age 0.0033*** Combined Ratio Underwriting expense/ net premiums written + loss and loss adjustment expenses incurred/ premiums earned -0.0101*** Aggregate Capital The sum of underwriting income (net of retroactive loss shock), investment income, other income and other gains in surplus and new capital paid in minus dividends 0.00026** Catastrophic Risk Exposure The proportion of catastrophic risk exposure: defined as direct premiums written in homeowners lines in catastrophic prone states, including coastal states and earthquake line in AL,FL, MS, SC, or TX to total premiums written -0.8205*** Organizational Dummy Equals to one if the insurer is a stock company and zero otherwise 0.2618*** Group Membership Dummy Equals to one if the insurers is single unaffiliated company and zero otherwise -0.8457*** Market Type Dummy Equals to one if the insurer is a direct writer and zero otherwise 0.1735** The explanation for parameters are not that straightforward Log odds ratio: to quantify how strongly the having or not having of the property A is associated with having or not having the property B in that population Note: Statistical significance at the 1, 5, and 10 percent levels is denoted by ***, **, and * respectively.

Summary of Findings Insurers’ rating grade is positively related to reinsurance utilization and negatively related to reinsurance exposure, consistent with our hypothesis Other control variables all contain expected signs and are statistically significant The results lend some support to our main argument that reinsurance is resilient in terms of maintaining insurers’ rating score in the face of financial crisis

Future Work Expand the three-year panel data when we obtain most recent data to generalize the conclusion about reinsurance resilience Include more dimensions of reinsurance transactions, like reinsurance concentration, to more comprehensively study reinsurance influence on insurers’ performance Endogeneity problem in explanatory variables should be considered Multi-dimensional rating information for insurers could be combined to analyze insurers’ financial strengthen

Thank you!