The costs and benefits of reinsurance

Abstract

Purchasing reinsurance reduces insurers’ insolvency risk by stabilising loss experience, increasing capacity, limiting liability on specific risks and/or protecting against catastrophes. Consequently, purchasing reinsurance should reduce capital costs. However, transferring risk to reinsurers is expensive. The cost of reinsurance for an insurer can be much larger than the actuarial price of the risk transferred. In this article, we analyse empirically the costs and the benefits of reinsurance for a sample of U.S. property–liability insurers. The results show that the purchase of reinsurance significantly increases insurers’ costs but significantly reduces the volatility of the loss ratio. With purchasing reinsurance, insurers accept to pay higher costs of insurance production to reduce their underwriting risk.