Interactions Between Risk-Taking, Capital, and Reinsurance for Property-Liability Insurance Firms

Theory and empirical evidence suggest short-run interactions between capital and risk. This paper analyzes the effects of reinsurance, as a new endogenous decision variable, on this policy mix. We examine this issue using a system of simultaneous equations applied to the U.S. property-liability insurance industry. The results identify significant interactions between capital, risk and reinsurance. The relationship between risk and capital is positive, indicating the effectiveness of regulatory mechanisms. Reinsurance is negatively associated with capital, for which it appears to act as a substitute. These results are sensitive to the level of capital held in excess of the regulatory minimum requirements. Weakly capitalized firms adjust their reinsurance and risk levels more quickly and try to rebuild an appropriate capital buffer. Unlike other decision variables, the capital ratio converges toward a long-run target level.