Equalization reserves for natural catastrophes and shareholder value: a simulation study

Abstract

This paper investigates the effects on the company value for shareholders of keeping equalization reserves for catastrophic risk in an insurance company. We perform an extensive simulation study to compare the performance of the company with and without equalization reserves for several standard profitability measures. Equalization reserves turn out to be beneficial for shareholders in terms of the resulting expected Sharpe ratio and also with respect to the value of the call option on assets at some reasonably large maturity time. Moreover, the expected total discounted tax payments are not smaller when using equalization reserves. The results are robust with respect to model parameters such as interest rate, time horizon, cost of raising capital and business cycle dynamics.