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.