Reinsurance Demand and Liquidity Creation: A Search for Bi-Causality

Abstract

We analyze the relationship between insurers’ liquidity creation and reinsurance demand. Early theoretical contributions on liquidity creation propose that financial institutions enhance economic growth by creating liquidity in the economy. Liquidity creation means financing relatively illiquid assets with relatively liquid liabilities. However, liquidity creation exposes insurers to financial risks. There is a trade-off between getting higher returns on risky investments and being able to compensate clients at a low cost when unexpected claims happen. Unexpected claims can be protected by reinsurance, which introduces a second trade-off between reinsurance demand and liquidity creation. This trade-off can be more important for insurers that have fewer diversification opportunities. Our main empirical results, from regularized GMM and ML-SME methods of estimation, show similar positive bi-causal effects between liquidity creation and reinsurance demand for small insurers (22% of insurance activity). The link between the two activities is not significant for large insurers (60% of insurance activity). We obtain mixed results for medium insurers. In all estimations, the standard GMM model is rejected.