Reinsurance Networks and Their Impact on Reinsurance Decisions: Theory and Empirical Evidence

Abstract

This paper investigates the role of reinsurance networks in an insurer’s reinsurance purchase decision. Drawing on network theory, we develop a framework that delineates how the pattern of linkages among reinsurers determines three reinsurance costs (loadings, contagion costs, and search and monitoring costs) and characterizes an insurer’s optimal network structure. Consistent with empirical evidence based on longitudinal data from the U.S. property and casualty insurance industry, our model predicts an inverted U-shaped relationship between the insurer’s optimal percentage of reinsurance ceded and the number of its reinsurers. Moreover, we find that a linked network may be optimal ex ante even though linkages among reinsurers may spread financial contagion, supporting the model’s prediction regarding social capital benefits associated with network cohesion. Our theoretical model and empirical results have implications for other networks such as loan sale market networks and over-the-counter dealer networks.

Keywords: Reinsurance Costs, Optimal Network Structure, Network Centrality, Network Cohesion