This study compares internal and external sources of capital in the insurance industry by analyzing reinsurance activity between affiliated and unaffiliated insurers. Tests are performed using data from a large sample of property liability insurers that are affiliated with at least one other property liability insurer. Results indicate that while demands for internal and external reinsurance have some factors in common, there are also cost-based differences in internal and external capital, as well as structural differences in demand for internal and external reinsurance. Results are consistent with previous theories related to internal versus external capital markets.

Reinsurance is a critically important part of the insurance industry. In 1997, insurers paid $198 billion in reinsurance premiums. Many reinsurance transactions take place between insurers and unaffiliated reinsurers, but the bulk of reinsurance transactions actually occur between affiliated insurers. Insurance firms are often affiliated as members of an insurance group. In 1997, 1724 out of 2740 U.S. property casualty insurance companies were affiliated with insurance groups. These 1724 group members accounted for ninety-one percent of industry direct written premiums in that year. Reinsurance activity within insurance groups is a common practice. In 1997, almost $157 billion were ceded within property casualty insurance groups as reinsurance premiums. Roughly eighty percent of reinsurance activity (by premium volume) occurs within groups rather than between insurers and unaffiliated external reinsurers. The use of reinsurance contracts among affiliated insurers may represent an extremely active internal capital market.

Some previous studies have tried to determine factors influencing the demand for reinsurance. Mayers and Smith (1982, 1990) propose hypotheses about the demand for insurance and subsequently test these hypotheses using data from the insurance industry. They contend the purchase of reinsurance by an insurance company is comparable to the purchase of insurance by firms in other industries. They hypothesize that demand for reinsurance may be a function of the structure of the tax code, expected costs of financial distress, the insurer’s ownership structure, investment incentives, information asymmetry, and comparative advantages in real service production, among other factors. In their study, internal and external reinsurance are not separated. As will be discussed in the next section, it is not clear that all of the hypotheses of Mayers and Smith (1982, 1990) regarding the demand for reinsurance would apply equally to intra-group reinsurance as to reinsurance with unaffiliated reinsurers. Garven and Lamm-Tennant (2000) examine the demand for reinsurance from a capital-structure perspective, but only include unaffiliated insurers in their sample, which represent a small, unrepresentative segment of the industry. Jean-Baptiste and Santomero (2000) examine the effect of asymmetric information on the trading of underwriting risk between insurers and reinsurers, concluding that such information asymmetry affects both the cost of reinsurance and the amount of reinsurance purchased. Their analysis does not consider the reduced level of information asymmetry involved when the insurer and reinsurer are part of the same affiliated group, and how that might influence the amount of reinsurance transacted.

Purchasing reinsurance is essentially a capital structure decision (Garven and Lamm-Tennant, 2000). Extensive work in the corporate finance literature seeks to explain how corporations choose their capital structure. Many studies focus on capital sources that are external to the firm such as debt and equity. Some focus on the single firm’s preferences among various sources of capital used to fund projects (Myers, 1984, Myers and Majluf, 1984, Greenwald, Stiglitz, and Weiss, 1984). Fazzari, Hubbard, and Petersen (1988) show that information asymmetries between recipients and providers of capital increase the cost of external capital relative to the cost of internal capital. As mentioned above, Jean-Baptiste and Santomero (2000) argue that information asymmetry increases the cost of reinsurance. In contrast to studies focusing on external capital, another line of research investigates internal capital markets in which a corporate headquarters allocates capital among members of a conglomerate. Several studies present hypotheses of costs and benefits of internal capital markets. Alchian (1969), Williamson (1975), and Gertner, Scharfstein, and Stein (1994) progress to a theory where consequences of internal and external capital markets differ by relative effects of asymmetric information and agency problems. More specifically, internal capital markets may be associated with decreased information asymmetries, increased monitoring incentives, decreased managers’ entrepreneurial incentives, and more efficient redeployment of assets.

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