Reinsurance and the management of earnings in the property-casualty insurance industry

Reinsurance transactions result in an immediate enhancement to policyholders' surplus (capital) via an increase in net income. First, the study investigates whether insurers enter into reinsurance transactions to decrease regulatory costs, to enhance their financial reports prior to capital issuance, and to manage taxes. The study distinguishes between traditional (risk) reinsurance and financial (non traditional) reinsurance, since the latter is perceived as a mechanism to enhance insurers' financial reports. Second, the study identifies three major sources of capital in the insurance industry--reinsurance transactions, understatement of loss reserves, and issuance of new equity--and investigates whether decisions to utilize these sources are made jointly. The regression results strongly support the hypothesis that stock insurers enter into retrospective financial reinsurance transactions to reduce regulatory costs. The results also support the hypothesis that insurers take into account their marginal tax position when entering into reinsurance transactions that increase taxable income. The simultaneity in decisions to utilize different sources of capital is modelled using a system of simultaneous equations. The results indicate that stock insurers treat reinsurance transactions and reserve understatement as substitutes. In addition, stock insurers appear to further enhance their capital in periods of new equity issuance by increasing the level of reinsurance transactions and reserve understatement. Finally, the results regarding mutual insurers are typically inconsistent with those of stock insurers, presumably due to differences in organizational form.