Reinsurance and Systemic Risk: The Impact of Reinsurer Downgrading on Property–Casualty Insurers

ABSTRACT This article analyzes the interconnectedness between reinsurers and U.S. property-casualty (P/C) insurers and presents the first detailed examination on the likely impact of major global reinsurer insolvency on the U.S. P/C insurance industry, in order to illustrate the potential systemic risk caused by the interconnectedness of the insurance sector through reinsurance. We find that the likelihood of a primary insurer's downgrade increases with its reinsurance default risk exposure from downgraded reinsurers. Counterparty primary insurers' stocks also react negatively to their reinsurers' downgrades. The negative effects also spill over to insurers that are not directly exposed to the credit risk of downgraded reinsurers. Despite the close interconnectedness, worst-case scenario analyses show that the likelihood of systemic risk caused by reinsurance transactions is relatively small for the U.S. P/C insurance industry. INTRODUCTION The danger of systemic risk to the financial services industry and the world economy as a whole, as triggered by the potential failure of the reinsurance industry, has drawn much attention from industry practitioners, regulators, and academic scholars since the early 2000s (Swiss Re, 2003; Rossi and Lowe, 2002; The Group of Thirty, 2006). Earlier research in general finds the risk is small and inconsequential. Such a view was challenged in the wake of the recent financial crisis, as the meltdown of insurance giant American International Group (AIG) severely deepened the crisis. As a result, a new round of research has emerged to examine the financial stability of the insurance industry and its potential to pose systemic risks to the whole financial system and to national/international economies (Geneva Association, 2010; Cummins and Weiss, 2014; Grace, 2010; Bell and Keller, 2009; Acharya et al., 2009; Harrington, 2009; Billio et al., 2012; Kessler, 2014; Chen et al., 2014). The discussion has continued and has become increasingly important, to the degree that various regulation parties have gotten involved in order to try to identify systemically important financial institutions. In 2011, the Financial Stability Board identified a set of Globally Systemically Important Financial Institutions (Weil Financial Regulatory Reform Center, 2012). Meanwhile, the International Association of Insurance Supervisors (LAIS) was tasked to develop an assessment methodology to identify Global Systemically Important Insurers, and an initial list is expected after April 2013 (IAIS, 2012). In those documents, reinsurance was proposed as an important factor to assess the systemic importance of an insurer. This increasing focus of regulation on the insurance-reinsurance industry definitely calls for in-depth academic research in the area. The literature generally uses three primary indicators to assess the degree of systemic risk posed by an institution/industry: size, interconnectedness, and substitutability. It is argued that the property-casualty (P/C) insurance industry may be subject to systemic risk because of its heavy dependence on reinsurance and the complexity of the reinsurance market (Cummins and Weiss, 2014). As argued in Acharya et al. (2009), "The reinsurance market increases the interconnectedness of the system exponentially and therefore might increase the systemic risk in the overall market" because of the "bilateral [relationship] in nature and [the lack of] adequate risk controls due to the opacity of bilateral markets." Despite the broad discussion on reinsurance and systemic risk in existing literature, little empirical work has been done to examine the actual interconnectedness of the insurance and reinsurance systems and test how significant the risk could be. Our research intends to fill this gap to some extent by investigating this interconnectedness through examining the reaction of P/C insurers to reinsurer downgrading and conducting scenario analyses to show the hypothetical impacts of major reinsurance groups' insolvency on the U. …