Regulation of Reinsurance Recoverables: Protection or Protectionism?

Presented by:

Cassandra Cole, Kathleen McCullough, and Lars Powell

American Risk and Insurance Association Meeting, 2006

Washington D.C.

2

Background

Reinsurance recoverables Paid losses & LAE Loss reserves Unearned premium reserves

Authorized/unauthorized reinsurer

3

Background

Credit for Reinsurance Laws Collateralization

Letter of credit / Trust account

Provision for unauthorized reinsurance Adjustment to statutory assets

4

Motivation

Scope: $240b in recoverables (2004) Almost 60% of industry surplus

Cost of collateralization: 15 to 60 basis points Estimate $200m - $500m annually

5

Motivation

Considerable public debate Lloyd’s of London: not necessary for old and

strong reinsurers (such as Lloyd’s) RAA (and others):

necessary to the financial strength of domestic insurers given differences in accounting methods and enforceability

Collateralization enables smaller insurers to access international reinsurance market

6

Research Question

Valuable solvency protection? Unfair trade protection?

What does the market think? How does the PFUR affect the price of

insurance?

7

Hypotheses Development

Price of insurance is negatively correlated with insolvency risk

All else equal, if consumers are concerned about collecting uncollateralized recoverables from unauthorized reinsurers, price will be negatively related to PFUR

8

Variables

Price = inverse of economic loss ratio [Net premium – dividends – UW expenses] /

[PV (incurred losses)] PFUR = provision for unauthorized reinsurance /

net premium

Controls: firm size, group membership, organizational form, underwriting leverage, concentration of underwriting exposure, and business mix

9

Data

NAIC Property-Casualty Database 2001-2004 25% of insurers report a provision for reinsurance

Firms Reporting PFUR Year Observations Mean PFUR 2001 405 $ 8,411,638 2002 395 $ 9,368,780 2003 399 $ 7,551,241 2004 301 $ 4,879,086

10

Methodology

PFURit = + Xit + % FOREIGNit + it Eq. (1)PRICEit= + (PFURit = PFURHATit) + Xitt + it Eq. (2)

where, PFUR = the provision for unauthorized reinsurance scaled by net

premiums written for insurer i in year t;X = a vector of exogenous financial and operational factors

controlling for the size of the provision for in equation (1) and variation in price equation (2) for insurer i in year t;

% FOREIGN = the percentage of premiums ceded to foreign reinsurers by insurer i in year t;

PRICE = the inverse of the economic loss ratio for the insurer i during year t; and

PFURHAT = the predicted values of the PFUR variable(s) in equation 1 for insurer i in year t used as instrument for these variable(s).

11

Summary Statistics

Summary Statistics

All Firms

With PFUR

Without PFUR

Provision for Unauthorized Reinsurance^* 0.013 0.05 0

Price^* 1.198 1.149 1.215

Size* 18.087 19.519 17.597

Affiliated Dummy Variable* 0.686 0.862 0.625

Stock Dummy Variable* 0.748 0.797 0.731

Direct Business to Surplus* 7.954 2.464 9.835

Line-of-Business Herfindahl Index* 0.679 0.589 0.71

Geographic Herfindahl Index* 0.608 0.425 0.67

Alien Reinsurance* 0.135 0.231 0.102 ^ Indicates variables windsorized at one percent and 99 percent; *Indicates means statistically different at 10 percent or better.

12

Results

Variable Coefficient Std. Err. Constant 0.039 0.4164 Provision for Unauthorized Reinsurance^ -4.8991 2.7730* Size 0.0519 0.0202** Affiliated Dummy Variable -0.0463 0.0375 Stock Dummy Variable 0.1234 0.0345*** Direct Business to Surplus -0.0001 0.0000** Line-of-Business Herfindahl Index 0.5428 0.0928*** Geographic Herfindahl Index 0.0045 0.0439 Robust standard errors; Line-of-Business and Year Controls For Space * significant at 10%; ** significant at 5%; *** significant at 1%

13

Conclusions

There are significant differences in insurers with and without PFUR.

PFUR is negatively related to price.

Initial results suggest Credit for Reinsurance Laws provide protection for U.S. insurers accessing international markets.

14

Further Research

Explore differences for primary insurers and reinsurers

More fully explore the determinates of PFUR

Evaluate proposals by Lloyd’s and other large insurers to reduce collateralization requirements for financially strong alien reinsurers