The Global Market for Reinsurance: Consolidation, Capacity, and Efficiency
This paper analyzes the economic impact of the wave of mergers and acquisitions currently underway in the global reinsurance market. Consolidation in this industry is driven by an increase in the frequency and severity of insured losses due to natural disasters as well as increasing demand for reinsurance for noncatastrophic losses. The theory of diversification explains the demand for global reinsurance as attributable to covariability of risk in local markets that can be reduced or eliminated through global diversification. Another important theoretical result underlying our analysis is Borch’s theorem, which holds that Pareto optimality in the market for reinsurance requires that all reinsurers hold a proportionate share of the “market portfolio”of insurance risk.
Our empirical analysis explores several hypotheses based on these theories. Our sample consists of the 130 largest global reinsurers over the period 1992-1998. We estimate industry capacity using a lognormal option pricing model to estimate the loss payments that would be made by reinsurers conditional on industry losses of various sizes. The results show that consolidation has increased the capacity of the industry to finance catastrophic risk. We also estimate mean-standard deviation efficient frontiers based on book value returns on equity in the industry. The results show that consolidation has improved efficiency in the industry by increasing average firm size, thus enhancing diversification. In addition, we find that less efficient and under-capitalized firms are more likely to be acquired than efficient and better-capitalized firms, thus providing the opportunity for acquiring managers to improve efficiency in the industry. Overall, the results strongly support the hypothesis that consolidation has improved both the capacity and the efficiency of the global reinsurance market.