1 Reinsurance Counterparty Relationships and Firm Performance In the U.S. Property-Liability Insurance Industry by J. David Cummins, Zhijian Feng, Mary A. Weiss Prepared for: CICIRM Kunming China July 19, 2013

2 Introduction Financial crisis has focused attention on interconnectedness within financial services industry Acharya 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

3 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)

4 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.

5 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)

6 Outline of Presentation 1. Hypotheses Development 2. Methodology 3. Data 4. Results 5. Conclusion

7 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.

8 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 diversification  Relative capitalization to size of risks insured  Large 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 mutuals  Mutuals more sensitive to concentrations of risk

9 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

10 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 power  Insurance buyer reluctance if too concentrated

11 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 affiliated  More 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 foreign  But collateralization of reinsurance liabilities

12 Methodology Outline of methodology 1. Measures of Reinsurance Utilization, Exposure, and Concentration 2. Firm Performance Measures 3. Specification of Regression Models

13 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)

14 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_Foreign HHI_RR_Foreign and %RR_Foreign  Unaffiliated reinsurance HHI_RPC_Unaffiliated and %RPC_Unaffiliated HHI_RR_Unaffiliated and %RR_Unaffiliated

15 Methodology: Measures of Firm Performance Traditional: ROA, ROE Efficiency: Cost, Revenue, Profit Efficiency 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.

16 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

17 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.

18 Methodology: Measures of Firm Performance IV Input Estimation

19 Methodology: Measures of Firm Performance V Output Estimation

20 Methodology: Regression Model for Determinants Determinants of Reinsurance Relationships y it = Measures of reinsurance counterparty utilization, exposure, and concentration TS=fixed year effects CS=fixed cross-section effects

21 Methodology: Regression Model for Determinants II  Measuring Firm-Specific Characteristics  Firm Size  Organizational Form (Stock=1)  Underwriting Risk: Catastrophe Exposure,  Investment portfolio risk: %STOCK, %MBS  Leverage: Premium/Surplus  Other Control Variables:  Group Affiliation  Geographic Concentration (HHI)  Lines of business controls (% premiums in line)  Line of Business Concentration (HHI)

22 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.

23 Methodology: Regression Model for Performance Relationship between performance and reinsurance utilization, exposure and concentration: y it = measures of performance Cost Efficiency (CE), Rev. Efficiency (RE), Profit Efficiency (PE), ROA, and ROE

24 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

25 Data and Sample  Data are taken from NAIC database for U.S. P/L insurers from 1993 to  Eliminate data for risk retention groups, extremely small firms, firms with negative premium, policyholder surplus and other outliers  Eliminate negative reinsurance transaction cessions  Final sample consists of firm-year observations for the analysis based on reinsurance premium ceded, and of 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

26 Empirical Results: Determinants of Reinsurance

27 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

28 Empirical Results: Performance and Reinsurance (RPC)

29 Empirical Results: Performance and Reinsurance (RR)

30 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

31 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.

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

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

34 Finer Measures of Reinsurance Variables

35 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.

36 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.

37 Conclusion III Performance 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.

38 Thank You!