Business cycles in insurance and reinsurance: international diversification effects

Abstract

This article examines the existence of a cyclical pattern in property-liability insurance for the US over the recent period 1982 to 2001 in connection with the international price of reinsurance during the same period. The fluctuations in the price of reinsurance during the past 20 years have been documented recently in the business literature. If the price of reinsurance decreases, reinsurance becomes more affordable for insurance companies and this will be reflected in more capacity, price competition and finally an increase in the loss and combined ratio. Our study is using a price index developed recently for this period of time and based on Swiss Re's global book of business. We show that the reinsurance price index exhibits a significant cycle of almost nine years. The beginning of our observation period starting in 1982 coincides with previously found structural breaks in the Loss Ratio (LR) series. We find that inclusions of the reinsurance price and/or the Money Market (MM) rate do not contribute much to the explanation of the LR in property-liability insurance, whereas the LR does help to explain the fluctuations in the reinsurance price index. This supports our hypothesis of the international diversification effects of reinsurance operation and a proliferation of cycles or large insurance shocks through international reinsurance services.

Acknowledgements

The authors are grateful to Bertrand Villeneuve, Emilio Venezian, David Cummins, Enya He and participants at the ARIA2009 meeting in Providence, RI, for their comments on an earlier draft.

Notes

¹ Berger et al. (1992) also argue that the role of reinsurance may be of greater importance in commercial liability than in other lines of business.

² Therefore, it is also not possible to test the theories against each other.

³ Literature on the capital constraint hypothesis is also relevant (Niehaus and Terry, 1993; Gron, 1994; Winter, 1994).

⁴ The data for the loss ratio and combined ratio are from Best's Aggregates and Averages, Property-Casualty (A.M. Best Co., several years).

⁵ It is calculated as net premiums (premiums minus commissions) in relation to the risk premium for Swiss Re's facultative business.

⁶ The ROL is defined as the price of reinsurance divided by the maximum possible loss under the reinsurance contract, averaged over contracts (definition from Cummins and Weiss, 2000, p. 184).

⁷ The US MM rate from 1980 to 2001 is from IMF, International Financial Statistics.

⁸ The authors like to thank Mr Rudolf Enz from Swiss Re for providing us with the data used in his study (Enz, 2002). There, the reinsurance price index is considered a perfect proxy variable for the worldwide price development and compared with financial results available in the US.

⁹ As the price index takes into account changes in retentions (the quantity of coverage) as well as ROL (definition given in Cummins and Weiss, 2000, p. 184), the reaction of the price index on hurricane Andrew was even stronger than the one of the ROL.

¹⁰ ROL is not included in the table as this series is too short.

¹¹ Regressions with a time trend show that the trend is zero and not significant; it does hardly change the other coefficients in these regressions.

¹² See Dickey and Fuller (1979). The process that generates the series should also have time-invariant coefficients. This may not be the case as shown by Leng (2000) for the combined ratio in the US.