Exposure to catastrophe risk and use of reinsurance: an empirical evaluation for the U.S.
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Exposure to catastrophe risk and use of reinsurance: an empirical evaluation for the U.S. Alejandro Drexler1 · Richard Rosen1 Received: 2 May 2019 / Accepted: 27 January 2020 © The Author(s) 2020
Abstract Reinsurance has long been used for tail risk protection. There is ample anecdotal information from practitioners about this dimension of reinsurance. The subject, however, remains largely unexplored in the academic literature given the lack of data about non-proportional reinsurance contracts. We develop a novel approach to measure the use of non-proportional reinsurance and use it to disentangle reinsurance used for catastrophe risk protection from reinsurance used for other motivations, for example regulatory capital relief. Our findings rely on a new measure of catastrophe risk that has strong explanatory power about insurers’ behaviour towards risk beyond what has been captured by existing measures. Keywords Reinsurance · Catastrophe losses · Tail risk
Introduction Property and casualty (P&C) insurers seldom go broke. This is surprising in an industry frequently buffeted by large unpredictable losses. For example, in 2005, when three of the 10 most devastating hurricanes in U.S. history occurred, only two insurers shut their doors despite insured catastrophe losses of USD 100 billion. These losses were not only three times larger than the average yearly losses from catastrophes, but represented 25% of the industry’s capital heading into 2005 (Munich Re 2017). In this paper, we present evidence on how P&C insurers use reinsurance to mitigate the effects of such large losses. Although theoretical models show that using reinsurance to cover tail events, such as hurricanes, can be the optimal choice for utility-maximising insurers (Vajda 1962; Borch 1962), few have studied this issue. This is in part due to the difficulty of measuring exposure to * Alejandro Drexler [email protected] Richard Rosen [email protected] 1
Federal Reserve Bank of Chicago, 230 S LaSalle, Chicago, IL 60604, USA Vol.:(0123456789)
A. Drexler, R. Rosen
catastrophes and in part due to the difficulty of measuring the share of reinsurance tailored to addressing catastrophe (CAT) risks (Engeström 1995). To examine the use of reinsurance for CAT risk, we introduce both a new measure of CAT risk and a new measure of the share of reinsurance that provides tail protection. Insurers pool many insurance policies and care mostly about the net risk from the policies in a pool. To the extent that the risks of the different policies in a pool are idiosyncratic (uncorrelated), there are diversification benefits from pooling. In most circumstances, the accident-related damages that any two auto policyholders may suffer are largely uncorrelated. This is why the losses of a large pool of auto policies can be predicted with some accuracy. However, there are risks that are systematic – that is, common across policies. One example of this would be the damage to cars from a hurricane. Such risks would hit many auto policies at th
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