How does actual relative to target leverage affect reinsurance use?

Abstract

This study investigates the relationship between capital structure deviation and reinsurance use. Prior studies on capital structures and hedging focus on how actual leverage is related to risk management tools. Using a sample of U.S. property–liability insurers from 2002 to 2021 and a simultaneous equations model, we argue and find that for overleveraged (underleveraged) insurers, the higher the actual leverage, the more (less) reinsurance use. Collectively, insurers with more deviations from their target leverages tend to purchase more reinsurance. Our evidence indicates that such capital structure deviations play an important role in dictating reinsurance use. We also find that these relationships are moderated by external shocks, including financial crises, catastrophic and pandemic events. The results imply that regulators may pay close attention to not only insurers’ actual leverages level but also their capital structure deviations, which could potientilly cause financial insolvency.