Interactions Between Risk Taking, Capital, and Reinsurance for Property–Liability Insurance Firms

Abstract

AbstractFinancial theory has long recognized the structural relationship between capital and risk. This article posits reinsurance usage as a new endogenous decision variable and analyzes its effect on this decision mix from a sample of U.S. property–liability insurance firms. Empirical results obtained from a simultaneous equation model confirm the mutual interactions among capital, reinsurance and risk taking. Risk taking is positively related to capital, which highlights the effectiveness of regulatory mechanisms and the relevance of the capital buffer hypothesis. Reinsurance is negatively associated with capital, for which it displays a substitutive effect. These results seem to vary with the insurers’ level of capitalization, affiliation with a group, size, and organizational form. Unlike other decision variables, the capital ratio is adjusted to its target level.