Abstract
We develop an agent-based simulation of the catastrophe insurance and reinsurance industry and use it to study the problem of risk model homogeneity. The model simulates the balance sheets of insurance firms, who collect premiums from clients in return for insuring them against intermittent, heavy-tailed risks. Firms manage their capital and pay dividends to their investors and use either reinsurance contracts or cat bonds to hedge their tail risk. The model generates plausible time series of profits and losses and recovers stylized facts, such as the insurance cycle and the emergence of asymmetric firm size distributions. We use the model to investigate the problem of risk model homogeneity. Under the European regulatory framework Solvency II, insurance companies are required to use only certified risk models. This has led to a situation in which only a few firms provide risk models, creating a systemic fragility to the errors in these models. We demonstrate that using too few models increases the risk of nonpayment and default while lowering profits for the industry as a whole. The presence of the reinsurance industry ameliorates the problem but does not remove it. Our results suggest that it would be valuable for regulators to incentivize model diversity. The framework we develop here provides a first step toward a simulation model of the insurance industry, which could be used to test policies and strategies for capital management.
Highlights
The modern insurance system1 has its roots in the establishment of Lloyd’s of London in the 1680s, which was named for a coffee house that catered to marine insurance brokers
We explore the role of the reinsurance industry in mitigating risks
Using the example of the insurance cycle, it will be highlighted that the model is able to reproduce realistic time series
Summary
The modern insurance system has its roots in the establishment of Lloyd’s of London in the 1680s, which was named for a coffee house that catered to marine insurance brokers. The first major crisis followed less than a decade later after the Battle of Lagos in 1693. During this battle a fleet of French privateers attacked an Anglo-Dutch merchant fleet causing estimated losses of around 1 million British pounds (Leonard 2013a; Go 2009; Anderson 2000). Risk assessment was inadequate and underestimated several risk factors.. Risk assessment was inadequate and underestimated several risk factors.3 Worse, it was some few underwriters that took the risk of writing policies for this merchant fleet, it was a significant part of the industry. The English parliament considered legislation that would have resulted in a government bailout (House of Commons 1693), but the bill failed (Leonard 2013a, b)
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have