Modeling financial reinsurance in the casualty insurance business

In this paper we examine the rationale for financial reinsurance in the casualty insurance business. This concept refers to an investment strategy that uses the financial markets to hedge insurance risk. The casualty insurer takes positions in derivatives on underlying assets, whose prices are highly positively or negatively correlated with specific insurance risks. We formulate the asset liability management problem for a casualty insurer, in the context of a dynamic, stochastic portfolio selection model. The optimal solution is a portfolio of financial assets earning a return that, including premium income from written policies, will guarantee compliance with the legal statutes in all but a few extreme states of nature. In this context we compare properties of optimal portfolios with and without the possibility of financial reinsurance. We let an alleged representative policyholder, endowed with a linear plus negative exponential utility function, evaluate the various optimal portfolios. We find that, in a regulated environment and when policyholders' utility functions exhibit reasonable levels of risk aversion, portfolios reflecting financial reinsurance dominate portfolios that are not financially reinsured.