When insurers buy reinsurance to manage their insurance portfolios, they are addressing the same balance between risk and return that investment managers assess to manage performance. In fact, some insurers use a conceptual tool of finance, known as the capital asset pricing model, to fine-tune their reinsurance decisions.

Investment managers use CAPM to evaluate stocks and bonds for their portfolios, weighing the potential returns of each asset against its contribution to the overall risk of the portfolio. That increment is known as the investment’s beta—the degree to which its risk is greater or lesser than the overall market.

Similarly, when insurers use a CAPM framework, they compare the risk reduction from potential reinsurance placements to their expected net costs, with a calculation of a ceded return on equity for each alternative. This calculation can compare reinsurance alternatives by showing the expected benefit (as a reduction in overall required capital) against the cost (as premium less expected loss recoveries). The lower the ceded ROE, the better.

The model focuses on the amount of corporate volatility. It neglects important internal uses of risk reduction in performance assessment, planning, compensation and pricing. Despite these drawbacks, there are times when CAPM does help reinsurance buyers quantify their risks and associated costs. But this framework must be used thoughtfully.

Buying in an Efficient Market

To use CAPM, a ceding company evaluates the expected net cost of each alternative reinsurance contract and weighs the protection provided against the ceding company’s overall risk position.

Here is an illustration where property concentrations are the key driver of risk to the ceding insurer. Insurers’ overall risk is not well correlated with investment market risks, so equity market betas are not significant factors for most insurers. However, because of the “stickiness” of regulated insurer capital, catastrophe risk should be considered as an undiversifiable risk, both within individual insurers and across the insurance and reinsurance markets. A contract’s effect on major losses becomes its key relative risk measure, like the betas in CAPM. The buyer’s decision process in this case would be to buy any reinsurance contracts that cost less than the value of the reductions in the company’s catastrophe probable maximum loss.

The analysis results in efficient market risk margins that do not depend on the type of product: catastrophe excess, risk excess, aggregate or pro rata. Theoretically, risk margins should be efficient across different markets: direct, facultative or treaty. So the company also should sell any direct contracts that are priced above the value of its increase in PML. Most insurance contracts outside of industry peak catastrophe zones are “good writes.” Companies can use the same math to evaluate reinsurance, manage their direct portfolio and price their original business.

The following is a plausible example where a buyer evaluates the trade-offs in terms of ceded ROE, the costs of potential contracts compared to the reduction in overall portfolio risk each offers.

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