Research Report Conclusions Opening of the Reinsurance Market, Demand for Reinsurance and Impacts on the Insurance Market1

1 (revised version)
Lauro Vieira de Faria*
Executive Summary: The aim of this study is to discover to how much Brazils reinsurance and insurance markets would be affected were the reinsurance market opened up and the monopoly of the Instituto de Resseguros do Brasil (IRB) brought to an end. We have studied the issue of reinsurance both theoretically and empirically in order to shed light on the issue. We find that at corporate level, the demand for reinsurance should be seen as a function of a companys taxation, ownership structure, leverage, credit rating and size, as well as its concentration in certain businesses, its tail (lag between a premium payment and a claim), the correlation between the return on investments and claims costs and the profitability of its assets. As concerns the domestic demand for reinsurance, the other factors to be added to this list are the scale of the market, the countrys financial development and existence of local compulsory reinsurance companies, uncompetitive markets and restrictions on foreign companies. An empirical study of the situation in Brazil shows that overall the national demand for reinsurance has behaved as forecast by economic theory. The price of reinsurance, the coefficient of insurance penetration and the concentration in the areas of life, health and auto insurance have had a significant negative impact on the demand for reinsurance. The same applies to the following factors: market share, rate of return on investments and concentration in housing insurance. One exception to the theoretical rule was the company size variable, which was found to have a positive impact. Ambiguous findings were obtained for taxation and leverage, while it would seem that foreign capital, geographical concentration and ownership structure/banks play no part in explaining the reinsurance demand. We also noted that reinsurance can be viewed as a kind of additional capital (or additional solvency margin) for the insurance market, and therefore one of its factors of production. An estimate of an insurance supply equation with this characteristic produced the result predicted theoretically in terms of the positive influence of reinsurance (and coinsurance) on direct insurance.
(*) Economist
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I should like to thank Ren de Oliveira Garcia Jr. and Cludio Contador for their inspiration, encouragement and assistance, Annibal Vasconcellos for her efficiency in collecting, clarifying and forwarding data, and the IRB and Funenseg libraries for the literature they made available. I also thank Robert Bittar and Renato Campos Martins F, President and Managing Director of Funenseg, respectively, for their support of this research. Without them, it would not have been possible. Naturally, any errors there may be in the text are the sole responsibility of the author.

By using these equations, a mathematical model was defined that could project the demand for reinsurance and the supply of insurance between 2005 and 2007 within an open reinsurance market. The projection exercise was designed with two basic hypotheses at its core: that opening the market would cause reinsurance prices to fall sharply and the IRBs relative net equity to rise sharply. The latter is taken as an indicator of the institutes capacity to supply ancillary services to insurance companies. This model demonstrates some undeniably positive impacts of opening up this market, which can be summarized as a more than 200% leap in demand for reinsurance over three years and an increase of some 40% in direct insurance revenues in the same period. I. Introduction: One of the key measures in modernizing the insurance market is the opening up of the reinsurance market. As is widely known, although Constitutional Amendment No. 13 of 1996 put an end to the IRBs legal monopoly in this business, Brazils reinsurance market has changed little in practical terms since then2. If the IRB could be praised for keeping the reinsurance activities performed in other countries inside Brazil and thus strengthening the countrys insurance companies by spreading the risk involved in auto reinsurance, there seems to be a consensus that the current model can no longer meet the needs of an expanded market. It would keep domestic prices higher than they would be under free competition and would curb the supply of new insurance products because there would be no corresponding reinsurance on offer. It would restrict competition, assuring the survival of less efficient companies reliant upon high cessions to the IRB, and it would prevent efficiency gains via improved risk pricing, greater access of local insurance companies to collateral services and greater speed in contracting and processing reinsurance. And it would block the entry of the foreign capital the country needs for its development. In a nutshell, maintaining the status quo would mean missing out on opportunities that could benefit not just the insurance market but the entire economy3. Today, most countries have put their faith in open reinsurance markets, the sole exceptions being Brazil, Cuba and Costa Rica. Clearly, membership of such a meager clan is a cause for concern of itself. Evidence of the problems created by the IRB monopoly can be seen in the alleged low penetration of reinsurance in Brazil. In 2003, this industrys revenues represented 7.5% of the direct insurance market, while in the largest markets in the region (Argentina, Chile, Colombia and Mexico), the rate varied between 18% and 33% (Bopp, 2005). However, the risk profile of these countries is rather different from Brazils, as they are more badly affected by natural disasters, which especially require reinsurance, as well as other factors. Compared with the rest of the world, Brazils reinsurance penetration rate is
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Law 9932 of 1999 regulated the privatization of the IRB and withdrew its prerogatives in the areas of inspection and setting industry standards. However, as no real change happened, the institute was granted back some of its rights in a natural reaction to the absence of any concrete steps to sell it. 3 There are also arguments against opening up reinsurance, such as the theses that without the IRB, there would be denationalization, since local insurance companies would not manage to compete with their overseas rivals, there would be a marked capital flight and greater price volatility, since the IRB effectively buffers the price variations during the international reinsurance cycle (Bopp, 2005).

higher than the international average of 6.7%, while its 0.53% share in the world reinsurance market surpasses the market share of the countrys direct insurance industry, which is 0.47%. Based on these figures, there are those who would argue that opening up the reinsurance market would have a negligible impact (Galiza, 1998). To the current date, the discussion of this issue from an economic standpoint has been pursued without any great recourse to theoretical and/or empirical considerations. This study intends to break the mold. It is divided into six sections: section II discusses the international literature on reinsurance from both a theoretical and empirical perspective; the third section gives a summary of the history of the reinsurance market in Brazil; the fourth looks into qualitative and quantitative aspects of the national demand for reinsurance; section V discusses analogous issues of the relationship between reinsurance and direct insurance output; the sixth section looks into the quantitative impact of opening up the reinsurance market with a view to predicting its impact on both the insurance and reinsurance markets; and the final section presents the conclusions of the study. II. Reinsurance in the international economics literature Reinsurance is the insurance of insurance companies equity risks that arise from any excess risk in their portfolios, allowing them to sell off the part of the risk that exceeds their retention capacity. The first reinsurance took the form of facultative contracts between insurers, the best known of whom met at Edward Lloyds coffee house in London the 1680s. By their very nature, facultative contracts can be complicated and costly. This is why the market developed what came to be known as treaties, by which the greater risks were automatically reinsured either jointly or individually. As insurance companies dragged their feet about sharing information with each other for these coinsurance treaties and in competitive market conditions, a new development came about: the advent of reinsurers, a special group of insurers specialized in supplying reinsurance, who operated according to the principle of uberrima fides, or utmost good faith. II.a. Karl Borchs Model Formally speaking, the seminal paper on the reinsurance market was written in the early 1960s by Norwegian actuary and economist, Karl Borch. He devises a reinsurance market which operates along the lines of a barter economy, where risk-averse companies with portfolios subject to losses can maximize the expected utility of their income. In order to do so, they exchange their portfolios on the market, and in so doing they end up with different portfolios from those they initially had, implying a certain degree of reinsurance (Borch, 1990). This author proves that under the conditions of the model, the optimal set of barters is equivalent to setting up a coinsurance pool, into which all companies put their initial portfolios and agree on a rule for sharing the claims payments for losses incurred by the pool. This rule depends on just a few variables: i) the statistical (probabilistic) properties of the risk of the individual portfolios; ii) the statistical ratios between a portfolios risk and the market risk, i.e. the risk of the pool of portfolios; iii) the prevailing attitude towards risk on the part of

the companies, and consequently the market; and iv) the total assets held by the insurance companies. The definitive design of a coinsurance pool depends on pinpointing the utility function of each companys income, and therefore of the market. Borch demonstrates that if these utility functions are HARA4, there is a linear risk-sharing rule once a coinsurance pool has been set up, which means the optimal situation is obtained by signing quota share (proportional) reinsurance contracts. Other types of utility function produce different results, such as when the pools risk sharing rules involve stop-loss reinsurance contracts (Borch, 1990, p.220). The reinsurance market model described above anticipates some features of the capital asset pricing model (CAPM). If the optimal arrangement of the coinsurance pool is a quotashare treaty, as in the case mentioned above, where each insurer ends up with a risk portfolio that is proportional to the markets risk portfolio, this is the equivalent of the CAPM proposal which states that under the models ideal conditions, each investor has a proportion of the market share portfolio. In the insurance market, the implication is that after an optimal coinsurance pool is set up, all the risk portfolios (net of reinsurance) are perfectly correlated amongst themselves. II.b. Criticisms of Borchs model Many criticisms have been made of Borchs model. Garven & Lamm-Tennant (2002) criticized the models emphasis on the issue of risk management to the detriment of the function of reinsurance in the management of decisions concerning capital, especially those related to the likelihood of insolvency. Additionally, though the model works for privately owned insurance companies, it is unable to take into account the complexity of larger insurers with a large proportion of shares traded on the market, which need to sign explicit and implicit contracts with their different stakeholders, such as their shareholders, managers, insureds, regulators and tax authorities. In these cases, postulating an unequivocal utility function of income for a given company, as Borch does, would mean that it would have to be stated whom this function would serve in terms of well-being, how this result was reached, and what kinds of risk it was hoped to reduce or eliminate through means of reinsurance operations. A more difficult criticism to rebut was formulated by the proponents of the CAPM model5. As they see it, unlike CAPM, Borchs model does not give the capital markets a role in determining the maximizing actions of insurance companies or their owners. Under the conditions set by CAPM, insurance companies shareholders must be seen as diversified investors who hold shares in an insurance company as part of a broad-based share portfolio. The possibility of diversification through the financial markets implies that these shareholders would be less concerned with unsystematic risk, which could be eliminated by diversifying their portfolios, than with the systematic risk of the market portfolio as a whole, which cannot be eliminated. Under such conditions, the CAPM model indicates that the

Hyperbolic absolute risk aversion, whose quadratic utility functions, like

u ( x) = ax bx 2 / 2 ,

where x is

income, are special cases. CAPM was developed independently by Sharpe (1964), Lintner (1965) and Mossin (1966).

return an investor would receive for holding shares in an insurance company or being their controller could be given by the risk-free interest rate plus a part (risk premium, equivalent of the loading of the insurance market) related exclusively to the systematic risk. Therefore, the maximizing decisions taken by investors in these companies could be described by modeling reinsurance decisions based on the expected utility of the income, which does not differentiate between systematic and non-systematic risk, as in the Borch model (for more on this see Cummins, 1990). However incredible it may seem, in the ideal world of the CAPM, both insurance and reinsurance are irrelevant for the shareholders of the company that cedes the risk. The hypotheses of CAPM, it should be added, are as follows: flawless capital markets in that there are no transaction costs and agents cannot interfere in prices; investors are risk averse and can take out and cede unlimited loans at a risk-free rate; and there are homogeneous expectations concerning the joint density function of the share returns. It has been demonstrated (Cummins, 1976 and Main, 1982 and 1983) that investors would hold an optimally diversified part of the market portfolio, which would protect them entirely against any pure (unsystematic) risk of the company they have invested in. In other words, by diversifying, they would be able to insure themselves without any cost of risk, so that if the company they invested in were to contract insurance or reinsurance to cover unsystematic risks, this would not raise the market value of its shares. Further, if the company were to take out insurance or reinsurance policies against systematic risks those which are correlated to the market as a whole this would bring them no benefit whatever. This is because the insurance companies that sell these policies, also basing their pricing on the CAPM, would charge premiums whose loading would exactly offset the taking on of this additional systematic risk. In the end, the companys market value would not be enhanced because the gain it would obtain by taking out the policies against systematic risks would be entirely offset by the higher premiums they would have to pay to the insurance companies for them to take on these risks. Basically, this was how the paradoxical conclusion was reached that it is irrelevant to a companys shareholders whether that company is insured or reinsured or not. II.c. Demand for reinsurance beyond the CAPM6 Obviously, a conclusion so far removed from reality could only have been reached because of the unreal hypotheses assumed by the CAPM model. The next logical step, then, was to research to what extent adopting less restrictive hypotheses would yield the result found in practice: that reinsurance is indeed a factor which adds value to insurance companies. One way would be to model the insurance market in a less simplified way. This was done by Doherty & Tinic (1981), who included not just insurers and reinsurers in their reference scenario, but also insureds. Their model assumes that the insurance market is perfectly competitive, that insureds are neutral towards an insurance companys risk of bankruptcy, that no transaction costs are associated to the purchase of reinsurance or share

This section is based extensively on Garven & Lamm-Tennant (2002, 2003), Carneiro & Sherris (2005) and Mayers & Smith (1990).

transactions, and that contracts between a companys stakeholders are complied with at no cost. This led them to the same conclusion as Cummins & Main above, that a companys shares will not gain value if they acquire reinsurance because when an insurance company rids itself of a risk, its gain is exactly offset by the excess premium charged by the reinsurer when it shoulders this risk. However, when some flexibility is introduced into the hypotheses, and insureds demand is no longer elastic As concerns an insurance companys risk of bankruptcy and that they are not perfectly diversified, what Doherty & Tinic show is that an insurance companys value can be enhanced when it contracts reinsurance. This is because reinsurance allows an insurance company under the threat of bankruptcy to charge higher premiums than it would charge if it had no reinsurance, thereby guaranteeing its shareholders their expected return. Along similar lines, Mayers & Smith (1982, 1990) established that insurance and reinsurance are important for public companies (including insurance companies) not because of their risk aversion but because of market flaws, such as taxes, transaction costs (including agency costs7), costs relating to the expectation of bankruptcy, etc. Blazenko (1986) chose to investigate the hypothesis of perfectly competitive direct insurance markets by introducing the possibility of insurable risks not being completely diversifiable. By so doing, he proved that reinsurance may add value to insurance companies in that it provides the market with additional capacity to spread risks. The influence of transaction costs was explored by Froot, Scharfstein & Stein (1993), who discussed their impact on investment decisions brought about by price differences between domestic and foreign financing, the former of which is known to be cheaper than the latter because of its lower transaction and agency costs. They proved that risk management strategies, of which reinsurance is one, are an effective tool for assuring companies liquidity and thereby enhancing their value. Below, we set out a more detailed description of the effects of the aforementioned market flaws on demand for reinsurance. i) Taxes If, as is the case in most countries, the marginal corporate income tax rate is an increasing function of earnings before tax, then net profit tends to be a concave function of gross profit8. This being the case, the mathematical expectation of net earnings is lower than the net earnings associated to the mathematical expectation of gross earnings. By acquiring reinsurance, the volatility of gross profit can be reduced and in theory a fine-tuned result can be achieved that is half way between the extreme probabilistic situations in which a company pays low taxes if it books a loss but much higher taxes when it is profitable. Thus, provided the reinsurance is of a moderate cost, it will allow companies to plan the gross earnings they intend to book, which will put them in the tax bracket that will provide them a gain relative to the situation in which the risk was retained. This effect was first mentioned by Mayers & Smith (1982, 1990).

An agency relationship is defined as a contract in which one person (principal) uses another person (agent) to perform some service in their name, which involves delegating authority. It is understood that the principal almost always incurs costs to assure the faithful compliance of the agent in this type of contract. 8 At least at certain intervals of the function that links one variable to the other.

Reinsurance is also a tool for setting tax shields between companies. Garven & Louberg (1996) demonstrated this feature of reinsurance in a market equilibrium model in which the insurance market seeks to minimize the aggregate value of its tax burden. In so doing, they found that reinsurance was an efficient means of allocating tax benefits for those companies that most needed them. They then extended model to investigate the international insurance trade, leading to the prediction that the differences between different countries tax rates would eventually create tax clientele, whereby the insurance companies in countries with lower taxes would provide reinsurance for insurance companies in countries with higher taxes. Internationally, then, the mean retention rates would be inversely proportional to the mean tax rates. A tentative empirical study into this was carried out by Outreville (1996) in a study into imported reinsurance (external retrocession) involving 42 developing nations. ii) Expected bankruptcy costs When an insurance company goes bankrupt this means it has failed to meet its obligations to its insureds and lenders. Bankruptcy costs can be described, then, as a kind of agency cost, and can be high. In the US these costs have been estimated at an average of between 11% and 17% of a companys value up to three years before its bankruptcy (Altman, 1984). This said, the protection provided by reinsurance or hedge mechanisms to reduce expected bankruptcy costs may enhance a companys value (Smith & Stulz, 1985). Nonetheless, it should be noted that this protection tends to be related to a companys size, with smaller companies turning to these techniques more often than large public corporations (Warner, 1977). iii) Adverse Selection Adverse selection takes place when an insurance company is unable to sift good risk from bad risk because of an asymmetry of information, which obviously makes it difficult for it to price policies. In the realm of theoretical economics, this was first discussed by Rothschild & Stiglitz (1976), who showed that an insurers optimal option restricts the range of policies available. To simplify, they show that if there were only two policies on offer, one with a low premium and a high minimum claim and the other with no minimum claim amount but a high premium, it would be possible to induce the good risk by buying the cheap policy and the bad risk by buying the expensive one. If we transpose this to the reinsurance market, the adverse selection problem explains the long-term implicit contracts between insurers and reinsurers as a means of reinforcing their mutual trust, thereby getting round the problem of information asymmetry, especially concerning risks that occur less frequently and involve higher sums, such as industrial property risks. This effect was demonstrated by JeanBaptiste & Santomero (2000), who showed that these implicit contracts allow new, significant information to be factored into the pricing of coverage, that insurers obtain a more efficient amount of reinsurance and at lower prices. iv) Agency Costs: Shareholders versus Managers Company executives are generally assumed to be less diversified that shareholders because they often have a high degree of investment in the firm for which they work. This induces them to reduce the companys risk exposure below levels that might be of interest to its shareholders. In a model that admits three different compensation schemes for executives, Doherty (2000) showed that i) those companies that offer compensation based on share ownership are very likely to hire hedge schemes, one of which is reinsurance; ii) the 7

executives from those companies which compensate them in the form of fixed salaries have similar behavior to the first group, but on a smaller scale; and iii) those companies that offer their executives stock option schemes are unlikely to contract this kind of protection9. This finding was confirmed empirically by Tufano (1996) in a study into the risk management practices of gold mining companies, which found that those mining companies that provided their employees with shares in the company took out more protection against risk than those that adopted stock options. v) Agency Costs: Shareholders versus Loan Creditors Under certain circumstances, it may make sense for a shareholder to restrict borrowing, even when this will benefit the company tax-wise and the capital markets can be assumed to be perfectly competitive. Myers (1977) proved this when he showed that there exist states of nature where a lucrative yet risky investment product partially financed by equity is not taken forward because the gains are mainly appropriated by the loaners and new shareholders to the detriment of older shareholders. This sets up a conflict between these agents which could spark off a state of underinvestment. Mayers & Smith (1987) and Garven & MacMinn (1993) showed that the problem of underinvestment can be eradicated by including insurance coverage in the contract for the loan taken out to make the project feasible. Jensen & Meckling (1976) argue otherwise, saying that under certain circumstances a shareholder may expropriate the lender by changing their risk decisions. They devised a sequential situation in which the controller first promises to choose a low risk investment project, then takes out a debt, actually chooses the high risk project, and ends up selling his shares on the market at a profit. Obviously, lenders avoid this kind of situation by incorporating the likelihood of the high risk project being chosen into the price of their loan. The loan cost thus augmented is an agency cost which the economics literature refers to as a problem of asset substitution. Leland (1998) showed that this problem can be eradicated if once the debt has been taken out, the controller voluntarily engages in hedges which, though they benefit the lender, are advantageous for the company if the tax deductions the greater leverage permits exceed the income transferred to the lender. vi) Optimal risk sharing As mentioned above, Borchs model draws no distinction between small, private insurance companies and large, public insurance corporations, which must sign implicit and explicit contracts with a variety of stakeholders. While the latter companies can have diversified portfolios which will rid them of unsystematic risk, the former have trouble so doing. Therefore, small, privately owned insurance companies will probably take out reinsurance for the same reason that individuals take out insurance: risk aversion. As a consequence, the demand for reinsurance should vary with companies size and ownership structure, with greater demand being found amongst small companies with a limited capacity to diversify. Mayers & Smith (1990) found, for instance, that associations like Lloyds, where contracts are provided by individual underwriters, use more reinsurance than large, public insurance

This is because the option introduces an asymmetry between the gain when the price of the share rises and the (small) loss when it falls, so that the scheme induces executives to demand volatility.

companies. The same applies to the subsidiaries and insurers of conglomerates, which require more reinsurance than their competitors. vii) Efficiency gains in the supply of services Apart from their main product, reinsurance companies also offer a number of ancillary services developed to take advantage of their corporate edge in dealing with low probability events and the global and wide-ranging nature of their activities. These include information about the best way to price policies, new product design, and consultancy about the entire lifecycle of a policy. These services add value to the companies that offer them by enhancing their efficiency. They are probably mostly hired by smaller insurers and those that are more geographically dispersed or that provide a greater variety of business lines (Mayers & Smith, 1990). To sum up, the actuary models of the reinsurance market (pre -CAPM) tend to emphasize the supply and demand of risk transfers in a barter market where the insurers risk aversion is the key factor at play. Financial models, for their part, emphasize the influence of the supply and demand of shares in the capital markets on the maximization decisions taken by insurance companies owners and/or shareholders. Thus, if for small companies the demand for reinsurance may be attributed to their owners risk aversion, for large companies with a high number of shares traded on the market, the demand is a function of tax benefits and market flaws such as agency costs, adverse selection and other factors. II.d. Demand for Reinsurance Empirical Tests In Table 1 below, we present a summary of the findings of four empirical studies into the demand for reinsurance10. They are: Mayers & Smith (1990), Garven & Lamm-Tennant (2003), Carneiro & Sherris (1990) and Outreville (1996). The left-hand column shows the variables11 that these authors use to determine the reinsurance demand. S(+), S(-) and NS stand for a positive and (statistically) significant relationship, a negative, significant relationship and an insignificant relationship, respectively. Blank fields mean that the variable was not tested by that author. As can be seen, none of the studies tested all the variables put forward and only Garven & Lamm-Tennant based their empirical test on a previously developed microeconomic model. As for the statistical methodologies employed, Mayers & Smiths work is based on a crosssection regression analysis of 1,276 American insurance companies operating in the core fields (property and casualty) in 1981. Garven & Lamm-Tennant use a panel regression analysis (combining cross-section and temporal series data) of 176 American insurance companies from the same business between 1980 and 1987. Carneiro & Sherris do the same for 98 Australian insurance companies from 1996 to 2001. In these three works, the dependent variable is the proportion of premiums ceded per company. Outreville, for his part, tests the factors that influence the premium retention rate in domestic markets in a cross-section regression analysis of 42 developing nations in 1988 and 1989.
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There are more empirical studies into the demand for insurance by companies outside the insurance market. The findings of these studies are not included as they do not cover the issue of reinsurance. 11 Some are proxy variables, i.e. they are used to substitute other relevant variables. Others are dummies, i.e. binary variables, in general, whose values can only be 0 or 1.

TABLE 1: Lag between Loss Report/Claim Settlement (tail) Mayers; Smith (1990) Tax rating (taxes/premiums) Tax Deduction Margin (tax shields) Ownership Structure/Control (dummies) Leverage Credit Rating Size Concentration on Business Lines Geographical Concentration Time Indicator (dummies) Volatility of Assets Lag betw. event and payment of claims (tail) Correlation betw. investment return/loss ratio Rate of return on investments Scale variable (premium/GDP) Financial Development [(M2-M1)/M1] Uncompetitive Market (dummy) Market restricted to National Cos. (dummy) Existence of compulsory local reinsurer (dummy) S(-) S(-) S(-) S(-) S(-) S(-) S(-) NS S(+) S(+) S(-) NS S(-) S(-) S(-) S(+) NS NS NS S(+) NS NS S(+) NS S(+) Garven; Tennant (2003) Carneiro ; Sherris (2005) NS Outrevill e (1994)

Looking at the cross-section and panel regression analyses of companies, only two variables appear in all three works: ownership structure and company size, and the findings for these are not consistent. In the studies by Mayers & Smith and Garven & Lamm-Tennant, a companys size measured as its total assets has a significant negative influence on the demand for reinsurance, but in Carneiro & Sherriss work, this is not significant. The ownership structure variable only has a significant positive impact in Mayers & Smiths work, while it is not significant for the other two. The variables investigated in any two of the papers are leverage, concentration in business lines, geographical concentration and time. Both the papers that investigate leverage find it has a positive, significant influence on demand for reinsurance, while the business concentration and geographical concentration have a significant negative influence. The time indicator is not significant. The influence of some other variables are investigated in individual papers: average tax rate, margin for tax deductions, credit rating, asset volatility, tail, ratio between the return on investments and the cost of losses, and the rate of return on investments. The tax variables and return on investments are not significant but the others have significant effects, predicted by the theory, i.e. the demand for reinsurance rises the greater the asset volatility is, the longer the tail is, and the lower the credit rating and correlation between returns/cost of loss events are12.

Curiously, Mayers & Smith, who were the first to discuss the potential effect of taxation on the demand for reinsurance, chose not to explicitly test this variable in the empirical part of their work.

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As mentioned above, Outreville studied the factors that affect the premium retention capacity in different countries. If we look at this another way, we can note the influence of these factors on the demand for foreign reinsurance, i.e. on part of the domestic demand for reinsurance. He notes that this demand seems high (low retention) in most developing nations, and puts this down to the fragmentation and small size of these domestic markets, which are often split between low value coverage such as auto insurance and high value high risk coverage, like industrial property insurance. In such a context, when the concentration increases, imposing a degree of monopoly on domestic markets, this may reduce the demand for imported reinsurance as insurance portfolios grow in size and diversity. Outrevilles findings were consistent with the hypotheses he formulated. He found that the size of domestic markets measured by their premium/GDP ratio, the development of their financial systems as measured by the ratio between quasi currency and currency, and the extent to which the domestic insurance market was monopolized all had a significant negative impact on demand for imported reinsurance, while the existence of barriers blocking the entry of foreign firms raised this demand. Outreville also tested the effect of compulsory reinsurance schemes in domestic markets on the demand for imported reinsurance, but the result was not significant. Thus, on a theoretical plane, it seems quite clear that for small insurance companies, their main motivation for taking out reinsurance is their risk aversion, while for large companies, factors relating to volatility and capital structure, tax costs, agency costs, adverse selection, bankruptcy costs, etc. have a greater weight. The empirical papers mentioned above confirm the importance of most of these motivations, with the exception of the paper by Carneiro & Sherris, which only finds companies leverage to be a significant factor. Meanwhile, as for applying these works to a study of the Brazilian scenario, there are clearly two shortcomings. None of them measures the influence on the demand for reinsurance of the reinsurance price (premium) or the efficiency gains achieved via access to ancillary services, of which the supply of new products is particularly relevant13. Interestingly, in the discussions about whether to open up reinsurance in Brazil, it is precisely these two variables that have been mentioned over and again as the most important, the latter more than the former, in that it is hoped that a in future competitive reinsurance market, reinsurance premiums will be reduced and new products supplied, both resulting in a greater volume of business for reinsurers and insurers alike14. Also, none of the papers explicitly models impact

Mayers & Smith mention this factor as part of the set of ancillary services that are important to reinsurance, but they do not measure its direct influence on the demand for reinsurance. 14 For more on this, see Bopp (2005), Morante & Sheppard (2000), Botti (2005) and Poon-Affat (1999). The omission of the efficiency gains via ancillary services variable could be inevitable in view of the difficulty of obtaining statistical data. But the complete disregard for the reinsurance price in studies into its demand as well as the price of substitute or complementary products seems particularly odd. In empirical cross-section studies of companies, the absence of this variable assumes the hypothesis that all companies pay the same reinsurance rates or that their behavior does not vary with the price. The first assumption could have an element of truth, but not the second. In analyses involving time variations, a disregard for the price variable violates the existence of reinsurance cycles, during which premiums can double in value. The same can be said for cross-section analyses of countries, given the differences between the countries based on their market structure, degree of development, risk profile, etc. In Brazil, where reinsurance is supplied by a monopolistic state-owned company, and where prices can be expected to vary considerably in a competitive environment, any demand estimate cannot,

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a reinsurance monopoly would have on the insurance market, though Outreville seeks to measure the effect of this variable on determining the premium retention rate on a national level. III. Overview of the Reinsurance Market in Brazil15 Until 1939, reinsurance in Brazil was done almost exclusively abroad either directly or indirectly via foreign companies operating in the country. The creation of the IRB, a stateowned company with a monopoly over reinsurance, coinsurance and retrocession operations had a dual purpose. Firstly, and in line with the nationalist ideology prevailing at the time, it was designed to strengthen the nations insurance companies by maximizing their retention rates and secondly, given the chronic shortage of capital, it was to keep reinsurance premiums previously passed on to other countries inside Brazil. In 1966, Decree/Law 73 granted the IRB the following legal powers: to inspect all compulsory and facultative reinsurance in Brazil and abroad; to organize and administrate consortia; to liquidate losses, to distribute the unretained part of insurance amongst the insurance companies; to place the excess risk on the domestic market abroad, and to take out any reinsurance (retrocession) of interest to the country. With time, it was also given the job of softening the impacts of external underwriting cycles on the internal insurance market16. In this case, the institute acts as a price buffer, so that when there is a hard market (strong foreign market), price hikes are not passed on in full or immediately to the cedants, and when the inverse occurs, the same is true for price cuts. Operationally, it is the IRBs job to set technical limits for each insurance business, which are added to the underwriting limits, solvency margins and minimum capital established by the national regulatory agencies, Susep and CNSP. In insurance companies, any risk over and above the technical limit must be transferred to another company via coinsurance and/or reinsurance (retrocession in the case of the IRB). Once the IRB accepts a reinsurance operation, it can choose to retain this additional risk if the sum is within its technical limit, it can retrocede it to the domestic market if the sum exceeds its technical limit but is within the retention capacity of Brazilian insurance companies, which is calculated as the sum of their technical limits plus the IRBs technical limit, or it can retrocede it to the foreign market if the sum exceeds the domestic markets retention capacity. Until 2000, retrocession was automatic and the IRB was paid a percentage commission. The operation was performed by means of quotas that were determined each year based on the net assets of each insurance company, the volume of reinsurance ceded and the result of ceded insurance operations. Insurance companies had to accept at least 50% of what they were offered, the remaining amount being placed with other insurance companies that were

then, fail to consider the effect of the reinsurance price as well as potentially the price of substitute or complementary hedging schemes, like coinsurance, for instance. 15 This section is partly based on Andrade (2001), Azevedo (1997), Bidino (1998), Bopp (2005), Castro (2003), Castro (2004), Castro & Duarte (2002), Forbes (2004), IAIS (2004), Souza (2001) and Morante (2000). 16 This applies more to large-scale industrial and transport risks. Risks in the auto, life and health businesses (more than 70% of the local market) follow the external reinsurance market in a less marked way and are more dependent upon domestic factors.

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willing to take on risks beyond their retrocession quotas. Meanwhile, coinsurance has worked as an alternative to this monopoly for its simplicity and speed, given that this kind of operation is normally more expensive than reinsurance17. Reinsurance contracts on the international market are signed based on the excess of all the insurance companies and the IRB, i.e. foreign reinsurance companies insure the Brazilian market as a whole18. Therefore, the IRB has wide-ranging normative and economic functions within the insurance market. As it sets plans and rates, it also defines the minimum level for insurance diversification and prices in the domestic market, since insurance companies must offer policies whose conditions and prices are in line with the IRB requirements. One might say that the market is priced by the IRB. As this is a market whose supply is dominated by a monopoly, any analysis naturally turns its attention to the monopoly-holder. Graph 1 below shows the development of the reinsurance premiums issued by the IRB since 1970 and the countrys gross and net demand for reinsurance, all as percentages of the insurance premiums issued. The data derive from the balance sheets annexed to the IRBs annual reports19. I define gross reinsurance demand as the difference between the total premiums issued by the IRB and the premiums relating to risks from abroad, while net demand is taken as gross demand minus internal retrocession. As can be seen, between 1970 and 1994 the reinsurance market shrank relative to the direct insurance market, though it has stabilized and seen some growth since then. The total of reinsurance premiums fell from an average of 28.1% of insurance premiums in the 1970s to just 5.4% between 1994 and 2000, rising to 7.2% between 2001 and 2004. A similar trend can be seen for the gross and net demand for reinsurance, which dropped from 27% and 12.5%, respectively, in the 1970s to 7.2% apiece between 2001 and 2004. The recovery during the last four years can be linked to two factors: a) the shift of premiums previously allotted to coinsurance consortia to reinsurance as foreign insurance companies which do not use coinsurance account for an increasing market share; and b) the strong growth of income in sectors of the economy that particularly require reinsurance, such as oil and gas, electricity and agricultural exports.

This is why it is hoped that the end of the IRB will also bring about the end of the coinsurance pools, because it is unlikely that an insurance company will seek out a competitor to share or facilitate reinsuring policies. 18 In larger scale operations, insurers normally deal directly with foreign reinsurers, and it is the IRBs job to approve these deals, taking on part or all of the risk and/or changing the retrocessionaire. 19 The way balance sheets and account plans are presented changed significantly during the period analyzed, which could make it difficult to make the historical series compatible.

17

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Graph 1: Premiums Issued by the IRB and Gross and Net Demand for Reinsurance

There was a convergence between total reinsurance premiums and the corresponding gross demand as of 1996, when the IRB practically stopped accepting risks from abroad. In the 1970s, the governments export drive led to the development of a policy of reciprocity designed to set up an exchange with Brazilian insurers, and encouraged the IRB and insurance companies to take on risks from abroad. In the IRBs case, such business peaked at 8.4% of reinsurance premiums issued (in 1980s), since which time it has dropped sharply. Meanwhile, there was a convergence between gross demand and net demand for reinsurance as of mid 2000, when the automatic internal retrocession scheme ceased, which had been part of the denationalization thrust started in 1996 when the legal monopoly enjoyed by IRB was brought to an end. Until June 2000, the IRB and the market had a retrocession consortium which maximized the domestic markets retention capacity. When new legislation (Law 9932/00, later suspended) put an end to such operations, the domestic market became more dependent upon the foreign market. Measured as a percentage of all reinsurance premiums, external retrocessions saw sturdy growth from the late 1980s onward, rising from 12.9% in the 1980s to 38.2% between 1994 and 2004. Graph 2 shows how retained premiums and internal and external retrocessions have fared, measured as a percentage of direct insurance premiums. As can be seen, internal retrocessions suffered a marked relative decline throughout the period, dropping from 20% in 1970 to negligible values since 2001. The current state of affairs is, then, a far cry from that of the early 1970s, when the policy of maximizing retention led the IRB to retrocede almost all the reinsurance premiums it ceded to the domestic market. As for external retrocessions, there is a milder relative decline, with this variable slipping from 3.6% of all direct insurance premiums on average in the 1970s to 1.8% in the 1990s. Since 2000, this percentage has recovered to 3.4%.

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Graph 2: IRB Retained Premiums and Internal and External Retrocessions

Graph 3 shows the quotients of the retained losses and the administrative and brokerage expenses over retained premiums. These quotients are, then, approximations of the better known terms, loss rate and expense ratio and the sum of both is roughly the same as the combined index20. As can be seen in the graph, from 1970 to 1987 the IRBs reinsurance operations tended to be profitable. Actually, in this period the sum of the aforementioned quotients was 69 on average. Generally speaking, from 1988 to 2000 the opposite was the case: the index in question rose to 124, with its peak of 214 coming in 1989. From 2000 to 2004 the institute again started to book underwriting profits expressed as an average sum of quotients of 77. The source of these changes quotients of the retained losses and administrative and brokerage expenses over retained premiums can be seen in the same graph. The loss ratio was low and moderate until the early 1990s, when it started to rise until the end of the decade, peaking at 85% in 1999 then declining sharply afterwards to previous levels. The expense ratio evolved differently. From 1970 to 1987 it was stable and low, like the other indicator, with an average of 34. From 1988 to 1994 it climbed sharply to 88, reaching its maximum level of 165 in 1989. From then on, the average fell to 28, much the same as in the 1970s.

20

We have used retained premiums rather than claims because of the changes in accounting practices between 1970 and 2004, which made it difficult to identify the real variation of reserves, and because of the instability of the impacts on revenues/expenses caused by the losses incurred in foreign operations, and exchange rate adjustments. This said, as the reinsurance market was in relative decline throughout most of the period in question, it is likely that more reserves were used up than built up, so the factor used has probably given the indicator an overall upward bias.

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Graph 3: Indicators of Loss and Expense Ratios and of the Combined Index

Graph 4 shows the two components of the expense quotient: administrative expenses and brokerage expenses over retained premiums. It can be seen that the first ratio is determinant of the (total) expense ratio in view of the fact that the latter ratio was steady until 1995 (average: 13) before falling to 8 between 1996 and 2002. This discussion shows that the period in which underwriting losses were incurred (1988 to 2000) can be split into two parts. In the first, there was a predominantly negative effect caused by increased administrative expenses (basically between 1988 and 1994), while in the second period (1995 to 2000) the overriding effect was brought about by increased Losses derived from Claims 21. Graph 4: Indicators of Total Expense, Administrative and Commercialization Ratios

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trend for the losses derived from claims and administrative expenses indicators between 1995 and 2000, indicating a national policy to offset losses in one case with gains in the other.

The sharp rise in administrative expenses between 1986 and 1994 is related to the runaway inflation during the period, and maybe the 1990-92 voluntary retirement plan and its ramifications. Interestingly, there is a reverse

16

Overall, the IRB has booked profits, as can be seen in Graph 5. From 1970 to 2004, the profitability of its net equity was 22.8%. However, this period can be split into three clear phases. The first goes until 1976, when the mean rate was 59.1%; the second, from 1977 to 1994, was marked by a drop of this variable to 7.2%; and in the third, running until 2004, it picked up to reach 20.4%. It is worth noting the contribution of net equity and financial revenues to the IRBs overall income. These figures, along with the percentage of retained premiums, stayed high throughout the entire period, with a mean of 88.1%. They grew exponentially until the mid 1980s (with a peak of 417% in 1985) and then fell in a similar manner thereafter. It is obviously these revenues that are behind the IRBs overall profitability during the periods in which there was a negative underwriting margin. If we look at the businesses with the most reinsurance, there has been little change since 1970. The IRBs turnover has been concentrated in traditional areas, such as property risks, followed by fire and transport, all of which involve high value policies. From 2003 to 2004, the fire insurance business brought in the greatest revenues, with 53% of retained premiums, followed by transport, with 24%, financial, with 12%, government, with 5%, personal insurance, with 7%, and foreign risks, with 1%. The personal insurance business is traditionally less reinsured, so the steady growth of this lines share of the overall business as of the mid 1980s, with more savings-type coverage than life assurance, is what mostly underpins the drop-off in demand for reinsurance relative to insurance premiums. Another factor is the decline in the relative share of the fire insurance business in the whole insurance market. While the natural disaster business has seen strong growth internationally, it has seen little change in Brazil because of its geography. Graph 5: Profitability of the PL and Ratio of Financial Revenues/Retained Premiums

Finally, the IRB must be viewed from the perspective of the global reinsurance market. It is actually very small alongside its counterparts in the globalized marketplace, whose main jurisdictions are in the Bermudas, France, Germany, Japan, the UK and the US. According to the International Association of Insurance Supervisors, in 2003 the world reinsurance market had a turnover of US$149.5 billion in gross premiums, of which US$117.8 billion was 17

not from life insurance (79% of the total) and US$31.7 billion was (21%) 22. In the same year, the Brazilian reinsurance market moved just US$ 996 million in gross premiums. The foreign market is considered competitive because it contains enough buyers and sellers for there to be price competition, there is free entry, and there is a considerable supply of venture capital, etc. The proof of the competitive nature of this market is the squeeze on profits it suffers periodically when there are unexpected losses. The industry operates with a standard price lag in function of losses which gives rise to its underwriting cycle. However, economies of scale and expertise in offering supplementary services and technological training are factors which could give larger companies a competitive edge. In the 1990s, the opening up of the markets, both domestic and foreign, along with the stabilization of the currency had a profound effect on the insurance market. Not surprisingly, the IRBs monopoly had to be reviewed. When the IRBs monopoly was ended on paper and there was talk of its privatization, some 20 foreign reinsurance companies set up offices in Brazil, encouraged by the example of Chile, whose market expanded sharply after reinsurance was opened up. Ten years on and little has changed, so much so that some of these offices have been closed. In other words, the fears of those against opening up the market have held sway, namely: 1) the obligation to raise underwriting standards and accountability; 2) the need for greater efficiency to compete on an international level; 3) the end of fronting, which allows some insurers to operate as brokers of most of the risks they underwrite, and 4) the fear of bankruptcy because of insufficient financial backing and technical know-how to take out contracts with large international reinsurance companies. IV. Demand for Reinsurance in Brazil: We initially attempted to estimate the aggregate demand for reinsurance in the Brazilian market by conducting a temporal series study upon annual data between 1970 and 2004. Next, these findings were further investigated by means of cross-section analysis (per company) and panel analysis for the years 2001-2004. As concerns the time series analysis, the explicative variables had to undergo some adaptations we had to deal with total sums or annual market mean values. Some variables had to be discarded due to the absolute lack of data concerning a given period, such as tax rates, ownership structure, credit rating, the tail, and the correlation between inversion return and claim costs. Other variables became meaningless, like geographic concentration or the effect of compulsory local reinsurance. Some gaps in the data had to be filled in by means of interpolation and the use of proxies. In addition, because until the early 1990s IRB refunded the domestic market a significant percentage of the reinsurance premiums, the dependent variable was faced with two possibilities: a) a gross demand for reinsurance, given the ratio between reinsurance premiums issued by IRB (as concerns Brazilian risks) and total premiums issued by the Brazilian market; and b) a net demand for reinsurance derived from the quotient between reinsurance premiums issued by IRB (domestic risks), net amounts of internal retrocessions,

Swiss Res estimate for the size of the global market in the same year was US$175.5 billion in gross premiums, of which US$146.0 billion was not for the life business and US$29.5 billion was.

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and total premiums issued by the Brazilian market. We chose the latter, for it seems to more appropriately express the monopoly and reinsurance role eventually played by IRB, by either shouldering part of the reinsurance risks or by placing the surplus of the collected amounts in the external market. The retrocessions pool managed by IRB does not seem to fully constitute a market demand, once its constitution and objectives, in terms of the currency exchange economy and the feasibility of minor insurers, goes beyond the mere economic plane. Therefore, the percentage of reinsurance premiums refunded to domestic market was considered to be external to the actual demand for reinsurance. Such adjustments led us to initially estimate a regression formula that comprehended all the possible explicative variables, as follows:

DRSS = + PRESS + ALVMER + KEST + VIDA + PENT + TAM + COMPET + JUROSR + DESFIN + DAIR + .PLIR + PASS

(1)

Some explanations about these variables are supplied below: a) DSSR: net demand for reinsurance, that is, the quotient between reinsurance premiums issued by IRB (domestic risks), net amounts of internal retrocessions (DRSSL), and total premiums issued by the Brazilian market 23 (PREM). The sources used were the annual reports and, in some cases, IRB annual balance sheets and Funensegs and Suseps databases. b) PRESS: average reinsurance price index, an approximation of the ratio between the retained reinsurance premiums, net commissions, and the sum of retained claims with variable provisions. The numerator reflects IRBs operating turnover and the denominator is an estimate of its total sum. Therefore, a proxy of the reinsurance average price corresponds to dividing the reinsurance turnover by the reinsurance sum measured likewise. This approach was used in foreign studies about the supply of life insurance and generates a product proxy with adequate stability over time24. We consider such concept applicable to the Brazilian reinsurance market, once the non-existence of catastrophic risks and its monopoly condition lead to similar stability characteristics25. From the theoretical standpoint, we expect the impact of such variable to be negative upon the demand for reinsurance. Our source of data is the same as the previous case. Unfortunately, given the lack of historical data, it was not possible to include coinsurance price in the equation, as coinsurance became a significant substitute for reinsurance in the mid 1980s. c) ALVMER: average market leverage, defined as the quotient between the insurers retained premiums and their own net equity (PL). Retained premiums are issued after the IRB has deducted the internal retrocessions. Coinsurance premiums were not considered because they

In the historic series, for some years, the direct premiums were reported rather than the issued premiums, the difference being accounted for discounts, cancellations and refunds. Additionally, such premiums include, eventually, those granted in social security operations of the VGBL type, that is, life insurance is reported in latu sensus. 24 We have also used the profitability of the net capital as a proxy of the reinsurance price. The regressions showed a negative sign which was, nonetheless, not meaningful, 25 The ideal procedure would be to use the estimates about retained claims or, in the lack of that, to reach an approximation by statistical treatment of the series of observed claims, which demand a long historic series. The lack of either condition prevented us from doing so.

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are annulled in the aggregate market value given the fact that the coinsurance accepted by an insurance company corresponds to the coinsurance underwritten by another. We expect the effect of this variable to be positive as leverage gets higher, which means more risk and bigger demand for reinsurance. d) KEST: foreign companies share in the overall insurance market turnover. The reason for including this variable is the claim that such companies, whose market share has increased considerably since 1996 because of the opening-up of legislation, are historically more demanding of reinsurance than Brazilian companies. The expected effect is, therefore, positive. e) VIDA: the share of life, health, and auto premiums in total premiums. We all know that the focus on such business lines, such as the ones aforementioned that involve less risk, reduces the demand for reinsurance. The expected impact is, therefore, to be negative. f) PENT: coefficient of domestic market penetration, defined as the ratio between issued premiums and GDP. That is a scale variable and theoretically, the effect upon the demand for reinsurance should be negative, as more mature markets tend to endure higher retention rates. g) TAM: insurers average company size, measured by dividing the quotient of premiums and GDP (PENT) by the number of insurance companies (NE). Our sources are Consultec, Funenseg, and Susep. Foreign studies that we analyzed measure company size as per their total assets. In Brazil, this datum series for the market as a whole between 1970 and 2004 is incomplete, so we had to use the volume of premiums issued by each company as per the GDP. As concerns company size, this seemed to be a better approximation than each companys mean aggregate net equity. As in the previous variable, we expect the impact of TAM to be negative, as bigger companies have higher retention rates. h) COMPET: binary variable that seeks to capture structural changes implemented as of the 1990s - the abrupt fall in inflation rates and, by means of changes in regulation, a more competitive insurance market and overall economy of the country. This variable is assumed to be 0 (zero) between 1970 and 1990 and 1 (one) as of then. If tighter competition implies in more market concentration, the expected demand for reinsurance is lower; if there is less competition, the expected demand should be higher. In other words, little can be assumed in this case. i) JUROSR: actual interest rates for overnight transactions hedged on federal bonds. This variable has been included as a proxy of the return rate of the insurers inversions. Therefore, in theory, the higher this rate the bigger the profit generation capability the insurers will have, and the lower the demand for reinsurance. The sources for this variable are ANDIMA, IBGE and IPEADATA. j) DESFIN: financial development, measured as the quasi-currency ratio in the GDP. The concept of quasi-currency was approximated by the difference between M4 and M1 monetary aggregates (means of payments). Positive effects are expected, as the busier and more

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complete the financial market, the bigger the supply of risk prevention instruments, as is the case of reinsurance. BCB and IBGE were our sources for this variable. l) DAIR: IRB administrative expenses such as the percentage of reinsurance premiums. By including this variable we aimed to approximate the impact of efficiency gains via supplementary services offered by the reinsurer. We acknowledge IRBs cuts in personnel in the last year and naturally, this affects the supply of the supplementary services aforementioned, as the ability to capture and transfer technology. Thus, this variable is expected to have a negative effect upon the demand for reinsurance. The sources for this variable are IRB annual reports. m) PLIR: IRBs net equity as a ratio of the insurers aggregate net equity. This variable serves the same purposes as the previous one, now comparing the evolution of IRBs equity against the insurers equity. Theoretically, the lower the ratio, the less able will IRB be to supply the supplementary services requested by the insurers. n) PASS: IRBs required liabilities as a ratio of its net equity. Overseas and in the case of big reinsurers, such variable is over 10 (ten). As concerns IRB, this ratio is lower and has been on a falling trend since the 1970s, when it reached 5 (five) and then dropped to the current 2 (two). IRBs low leverage, on one hand, guarantees its solvency; on the other hand, it prevents the supply capability at the hardest times of the economic cycle, when financial revenues are critical for the companys profitability. Therefore, PASS aims to address IRBs occasional insufficient supply and in particular, issues related to efficiency gains via supplementary services supplied by big reinsurers to the insurance market. This variable is expected to have a positive effect upon the demand for reinsurance. The regression that refers to equation (1) showed five variables (KEST, JUROSR, DESFIN, DAIR e PLIR) that are statistically meaningless (indifferent of zero) and so have been excluded from the following regression26. Based on the currently available data, this seems to be the most appropriate regression to explain the o object of this study within the focus upon the time series. The estimated equation is the following:

DRSS = + PRESS + D ( PRESS ) + ALVMER + D ( ALVMER ) + VIDA + PENT + TAM + COMPET + PASS

(227)

26 27

The regression that refers to equation (1) is shown in Annex I. D in equation (2) represents the first difference, that is, D(PRSS) = PRSS - PRSS(-1).

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Table 2 below shows the descriptive statistics of these variables:

TABLE 2: Descriptive Statistics Temporal Series
Sample: 1970 2004 DRSS Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability Observations 9.69 9.95 17.42 4.28 3.94 0.24 1.91 2.06 0.36 35 PRSS 1.42 1.33 2.53 0.52 0.52 0.43 2.67 1.25 0.54 35 ALVMER 1.67 1.79 2.73 0,66 0,56 -0.19 2.2 1.14 0.56 35 PENT 1.42 1.04 2.55 0.83 0.59 0.65 1.77 4.68 0.1 35 TAM 0.01 0.01 0.02 0.0 0,0 0.59 2.91 2.04 0.36 35 VIDA 51.63 47.05 76.00 29.40 18.41 0.12 1.27 4.82 0.09 35 PASS 2.64 2.3 5.5 1.7 0,88 1.64 5.37 23.94 0 35 COMPET 0.4 0.0 1.0 0.0 0.5 0.41 1.17 5.87 0.05 35

As central trends of the domestic insurance market we can identify low leverage, little reinsurance practice, operations mostly concentrated on life, health and auto insurance, and low penetration coefficient. PRSS and PASS variables are indicators whose absolute value only makes sense when compared to other markets (we shall recap on this point below). The resulting platykurtic distribution is, in general, right-skewed and within normality. The results of the regression are presented in Table 3 below and regressions show an adequate explanation power. R shows a mean 90% and the low probability of F-statistic indicates the relevance of the set of explicative variables. Both the 1.93 Durbin Watson Test (DW) and the Breusch Godfrey Test statistics indicate the absence of serial correlation in the residues. The regression did not show any signs of heteroscedasticity, according to Whites test. The coefficients of the explicative variables are statistically different from zero, with probabilities lower than 94%, as per the respective standard errors, except for the first difference in leverage. The coefficients show the expected signs: negative signs for reinsurance price (PRSS) and for penetration coefficient (PENT), and positive signs for market leverage (ALVMER), the share of life, health, and auto premiums in total premiums (VIDA), and IRBs required liabilities as a ratio of its net equity (PASS). The COMPET variable had a positive coefficient, thus showing that the more competitive environment of the 1990s fostered an increased demand for reinsurance. The initial differences between the PRESS and ALVMER variables aimed to account for time dynamic effects. Both global and steady-state cases show the impacts as expected according to theory, the former with negative while the latter positive.

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TABLE 3: Demand for Reinsurance Temporal Series

Dependent Variable: DRSS Method: Least Squares Sample(adjusted): 1971 2004 Included observations: 34 after adjusting endpoints Variable C PRSS D(PRSS) ALVMER D(ALVMER) PENT TAM VIDA PASS COMPET Coefficient 14.38 -1.89 1.65 1.88 -0.45 -11.98 1270.44 -0.15 0.82 3.93 Std. Error 2.28 0.81 0.62 0.72 1.14 2.66 228.67 0.05 0.42 1.70 t-Statistic 6.30 -2.34 2.67 2.61 -0.39 -4.51 5.56 -2.90 1.96 2.31 Prob. 0.00 0.03 0.01 0.02 0.70 0.00 0.00 0.01 0.06 0.03 9.81 3.94 3.81 4.26 24.77 0.00 0.86 0.83

R-squared 0.90 Mean dependent var Adjusted R-squared 0.87 S.D. dependent var S.E. of regression 1.44 Akaike info criterion Sum squared resid 49.72 Schwarz criterion Log likelihood -54.70 F-statistic Durbin-Watson stat 1.93 Prob(F-statistic) Breusch-Godfrey Serial Correlation LM Test (n lags=01) F-statistic 0.03 Probability Obs*R-squared 0.04 Probability

The variable company size shows a significant and positive sign in the regression, thus the opposite of what was expected, indicating that ceteris paribus, Brazilian insurance companies growth led to a higher demand for reinsurance. That was not predicted by theory, but is to be considered a possibility if such growth is not supported by changes in the insurers ownership structure. We should remember that the connection between demand for reinsurance and the insurers company size is established by ownership structure: within the context of the CAPM model, bigger insurers are usually open-capital companies and operate actively in the capital markets; as a consequence, they have more access to asset diversification mechanisms that reduce exposure to unsystematic risks and thus, their need for reinsurance. If companies grow but keep stable ownership structures, the aforementioned effect may not occur. It should be noted that in the empirical study conducted by Carneiro and Sherris (2005) for the Australian reinsurance market, such variable was not significant. Until recently, in Brazil, the insurers growth was not followed by significant changes in ownership structure due to little market competition. This is possibly the reason for the positive sign that was found. This estimate was carried in time series through a multivariate regression. Next, we conducted estimates for demand through crosssection regression and/or panel data regression at corporate level in order to verify the previous findings. Such approach undoubtedly requires several adaptations. Firstly, we must specify which companies will be the set object of the statistical study. Most foreign empirical studies focused on elementary insurance companies (property/casualty), either because such companies allow for a less heterogeneous sample of the insurance market 23

or because these companies are considered to operate in a significantly different way from those that specialize in insurance plans for individuals. That also explains the fact that in several countries, they have to be legally constituted one way or another. In Brazil, although this legal distinction has been recently established, in practice, the difference between the two sets of insurance companies is still too little to justify a single study focused on both sets. Another problem to be solved regards the groups of insurers. Data collected by SUSEP between 2001 and 2004 reveal that 118 insurance companies operate in Brazil. However, several of them belong to banking or insurance conglomerates so that part of a given insurers demand for reinsurance may be addressed by another company that belongs to the same conglomerate. It thus makes sense to focus upon company conglomerates rather than individual insurers. Searching the Internet sites of the referred conglomerates, we were able to collect several balance data and to study a set of 61 groups of insurance companies and individual insurers between 2001 and 2004. Seeking homogeneity, we chose to keep the same set of companies along all these years so that groups of companies or individual insurers mentioned as concerns one specific type of data are not excluded from the sample. This set of companies for the year 2001 is presented in Annex II. Finally, instead of time series analysis, the cross-section focus did not take into account those figures that refer to health insurance, as these refer to data per company that pertains to SUSEP database. Having defined the set of companies, the next step was to establish the equation to estimate the demand for reinsurance and, therefore, the variables to be considered. Our starting point was Garven and Lamm-Tennant (2003), aforementioned, who studied a set of 176 American insurers that operated in elementary insurance between 1980-1987. We shall start our analysis upon cross-section regression, moving on to panel data regression. This, the equation of the estimated demand for reinsurance for 2001-2004, through cross-section analysis, in the following:

drs = + .alv + .tam + .hh + .vida + .tax + .inv + .geo + .kest + .banc + .d1 (3)
The Greek letters represent the parameters to be estimated. The abbreviations, in the specific order and per company, refer to the demand for reinsurance, leverage, company size, market share, concentration in life and auto business, rates, inversion revenues, geographic concentration, and mean foreign capital. The variable banc is a dummy that aims to verify the influence of the factor belongs to a banking conglomerate upon the demand for reinsurance. Therefore, this variable takes up the value of 1 if the group or individual insurer is a banking institution and 0 if otherwise. The variable d1 is another dummy assigned value 1 if the group or individual insurer specializes in home insurance and 0 if otherwise. Except for the latter variable, included in the equation to allow for better regression line adjustment, the reason for considering the other variables are the same as for the focus on time series. The demand for reinsurance at corporate level and at a given year (drs) was defined as the quotient of the paid reinsurance premiums, net accepted retrocessions, over direct insurance premiums. Leverage (alv) was defined as the quotient of direct premiums over net equity. Company size (tam) was attributed by the natural logarithm of total assets. A given companys 24

market share (hh) was based on its direct premiums and was attributed by the respective Hirshmann-Herfindah indexl28. The concentration in life and auto business (va) was set by the share in the premiums issued for these types of insurance in total premiums. Tax rating (tax) was established as income tax and social welfare taxes expenses as the percentage of direct premiums. The inversion return rate (inv) was set as the sum of net financial revenues plus equity as a percentage of total assets. Geographic concentration (geo) was based on a given insurers or a group of companies operation in different states of Brazil. Therefore, for instance, a given company operating in the states of So Paulo and Rio de Janeiro but not operating in the rest of the country was assigned a mean value equal to the share of these states total GDP in the countrys GNP. Foreign capital share (kest) was set by the number of shares held by this shareholder against the total shares issued by a group or an individual insurer. The source of primary data is SUSEP. A number of potentially important variables were not considered, like tax shields, credit rating, asset volatility and the correlation inversion returns/claims costs, given the lack of respective data. Focusing on cross-section analysis has both pros and cons when compared to time series analysis. One of the obvious advantages was studying the reaction at corporate level. This way, variables such as a companys market share, its geographic concentration, tax rating, and ownership structure effects like those captured by the dummy banc can only be investigated through cross-section analysis (or panel analysis, which integrates both foci). Analogously, the variable inversion return rate - which is approximated by real interest rates in time series analysis - can be more accurate in cross-section regression analysis. On the other hand, a major disadvantage was not being able to include the variable reinsurance price in the regression. In fact, at corporate level, the indicator used for this variable in time series analysis the ratio between retained reinsurance premiums, net commissions, and the sum of retained claims with the variable on the provisions showed little reliability, given its instability. For the same reasons, it was not possible to consider the variable coinsurance price, which is a substitute product for reinsurance. The regression did not comprise the ratio between IRBs required liability/net equity which, in the time series analysis, approximated the variable efficiency gains via supplementary services, for absolute lack of data at corporate level. Table 4 below shows the main descriptive statistics of the aforementioned variables in the period 2001-2004.

28

This index, better known as HH, is defined as the square sum of the percentage market share of a given company.

25

TABLE 4: Descriptive Statistics of the Variables Under Investigation

Sample: 2001 2004 DRS Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability Observations Cross sections 130.05 52 836 -30 188.87 2,16 7.12 361.99 0 244 61 ALV 257.7 235.5 1754 22 186.68 2.98 20.41 3442.27 0 244 61 TAM 52.09 51 76 32 8.36 0.48 3.02 9.33 0.01 244 61 VIDA 73.54 83 100 0 27.34 -0,98 2.95 38.9 0 244 61 HH 1537,14 7.5 57065 0 6793.42 6.44 46.56 TAX 14.05 9 222 -360 46.18 -1,48 23,01 INV 79,2 77 232 -50 41.02 0,3 3.86 11.02 0 244 61 GEO 74.02 100 100 7 31.26 -0.78 2.17 31.78 0 244 61 KEST 41.93 31 100 0 44.29 0.32 1.32 33.03 0 244 61 BANC 0.18 0 1 0 0.39 1.66 3.77 118.42 0 244 61 D1 0.07 0 1 0 0.25 3.51 13.32 1583.83 0 244 61

20973.75 4160,59 0 0 244 61 244 61

As the table shows, also in terms of central trends, the set of insurers under study may be described as companies that make little use of reinsurance, operate with low leverage, focus more on life and auto business both in terms of size and market share - operate in most of those states of Brazil that have significant GDP, collect little amounts of taxes, get good inversion return rates over assets, show a significant foreign capital share as well as a low share of banks and companies that focus on home insurance. Distribution is, in general, rightskewed leptokurtic and not within characteristics of normality. The results of the cross-section regressions are shown in Table 5 below29.

The econometrics software used was E-Views 3.1. Due to problems to export data in Excel sheets with Latin notation (thousands separated by points and decimals by comas)to E-Views that uses English notation (the reversed use of points and commas), the variables drs, tam, tax and inv were multiplied by 10, and the variable alv, by 100.

29

26

Table 5: Cross-Section Regressions 2001-2004

Dependent Variable: DRS Method: Least Squares Sample(adjusted): 1 61 Included observations: 61 after adjusting endpoints 2001 Variable C ALV TAM VIDA HH TAX INV GEO KEST BANC D1 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) Coefficient 754.65 -0.18 -3.00 -5.78 -0.01 -0.38 0.13 -0.02 -0.32 -2.35 -204.71 0.67 0.61 110.1 606091.3 -367.27 2.25 115,54 175.53 12.4 12.78 10.25 0.00 t-Statistic 5.42 -1.97 -0.96 -9.35 -2.14 -0.82 0.31 -0.04 -0.89 -0.05 -3.08 2002 Coefficient 923.61 -0.16 -3.13 -7.19 0.00 -0.21 -0,3 0.07 -0.32 -8.29 -256.75 0.78 0.73 99.94 499373.8 -361.37 2.09 133,36 193.15 12.21 12.59 17.41 0.00 t-Statistic 7.14 -2.62 -1.17 -11.62 0.24 -0.6 -0.89 0.13 -0.97 -0.2 -4.19 2003 Coefficient t-Statistic 802.33 -0.17 -1.46 -6.65 0.00 -0.18 0.08 -0.24 -0.58 20.69 -259.49 0.82 0.79 88.71 393437.41 -354.1 1.77 137.75 192.2 11.97 12.35 23.17 0.00 7.26 -1.93 -0.59 -13,84 -0.33 -0.82 0.27 -0.49 -1.9 0.53 -4.96 2004 Coefficient 893.87 -0.12 -3.41 -6.82 0.00 -0.55 0.29 0.00 -0.85 35.31 -248.92 0.81 0.77 95.03 451488.18 -358.29 1.77 133.54 197.79 12.11 12.49 21.00 0.00 t-Statistic 7.22 -1.21 -1.4 -13.03 -0,06 -1.72 0.78 0.0 -2.7 0.85 -4.68

Regressions show adequate explanatory power (adjusted R-squared are over60% in the four years) and the set of variables were found significantly different from zero, as per Fstatistic. Coefficients of the variable life show negative signs and are statistically different from zero, as predicted by theory and found through time series analysis. In other words, the higher the concentration on this insurance segment, the lower the demand for reinsurance. Coefficients of variable leverage show negative signs in the four regressions, being non-significant only in 2004. The results are, therefore, contrary to what was predicted by theory and found in the time series regression. In fact, a priori, we should expect that the higher the leverage - thus implying in higher risks - the higher the demand for reinsurance would be. Coefficients of variable company size point to negative impacts over the demand for reinsurance, as expected by theory, but these were statistically different from zero in the four years. The variable market share, calculated by HH, was found negative and statistically different from zero, as expected, only in 2001; and in the other years, indifferent from zero. The variable tax rating had negative impact on the demand for reinsurance, but only in 2004 this effect was statistically different from zero to 10% of significance. Coefficients of variable foreign capital were negative in the four years and found significant in 2003 and 2004, thus pointing to the possibility of less demand from foreign companies than from domestic companies30. The variable concentration on home insurance, assessed by the dummy d1 showed negative and significant coefficients in the four years, thus indicating that companies that focus on this type of insurance, notedly Caixa

It should be noted that such result is contrary to what is sometimes claimed as reference to foreign companies behavior.

30

27

Econmica Federal, show lower demand for reinsurance than the others. The variables inversion return rate, geographic concentration and belonging to a banking conglomerate did not show statistically different from zero coefficients in any of the four years. Cross section analysis shed light over certain aspects not assessed by time series analysis. The statistical problem with the latter is that the estimated coefficients are possibly contrary to what is expected, given the non-identified heterogeneity between the several components of the data set31. Panel data studies might correct this problem, that is, regression analyses with both dimensions spatial and temporal. Combining time series and cross-section analysis can improve estimates in three aspects: a) it allows for the correction of the statistical problem mentioned just above; b) it unveils dynamics that are otherwise rarely detected in cross-section analysis; and c) it can significantly increase the number of observations when we multiply the N observations in cross-section analysis by the T time periods. Additionally, the results and referents aforementioned for the variables leverage and company size, contrary to what was assessed through time series regression, reinforce the argument for conducting panel data analysis. Having said that, for panel data analysis, the estimated equation was the following:

drs = + .alv + .tam + .vida + .hh + .kest + .tax + ..inv

(4)

Again the Greek letters represent the parameters to be estimated. The signs refer, per company, to the same variables in equation (1). As variables geo, banc and d1 hypothetically remain the same for every company along all the years under study, they could not be included in equation because they lead to multicollinearity and, therefore, do not allow for the inversion of the explicative variables matrix. This represents a disadvantage of panel data analysis over cross-section analysis. We also attempted at a specification of equation (2) which includes as proxies of the reinsurance price and of the efficiency gains via supplementary services the same indicators used in time series analysis. This implied the hypothesis of variable constancy for all the insurers in a given year. The estimation did not yield consistent results for reinsurance price, thus making this hypothesis unreal and so both variables were excluded from the regression. The results of the regression that refers to equation (4) are shown in Table 6 below.

31

Na analogous problem occurs in time series regressions, when the contrary may occur given non observed heterogeneity between diverse periods of time.

28

T a b le 6 : P a n el An a lys is F ix e d E ffe c ts (2 0 0 1 2 0 0 4 ) D e p e n d e n t V a ria b le : D R S M e th o d : P o o le d L e as t S q u a re s (fix e d e ffe c ts ) S a m p le : 2 0 0 1 2 0 0 4 In clu d e d o b s erv a tio n s: 4 (2 0 0 1 - 2 0 0 4) N u m b e r of cro ss -s e ctio ns u s e d : 6 1 T o ta l p a n e l (b a la n c e d) ob se rv a tio n s: 2 44 W h ite H ete ro s k e d as tic ity-C o n s is te n t S ta n d ard E rro rs & C o v a ria n ce V a ria b le ALV TAM V ID A HH KEST TAX IN V R -s q u a re d A d ju s te d R -s q u are d S .E . of re g res s io n F -s tatistic P ro b (F -statis tic ) M ean dependent var S .D . d e p e n d e nt va r S u m s q u are d re sid D u rb in -W a tso n sta t C o e ffic ie n t -0 .0 7 9 7 .5 6 -1 .6 4 -0 .0 0 3 6 0 .3 0 0 .0 8 -0 .1 9 0 .9 7 0 .9 6 3 6 .6 4 1 0 4 6 .9 0 .0 0 1 3 0 .0 5 1 8 8 .8 7 2 3 6 2 7 1 .3 4 2 .0 0 0 .0 0 5 5 0 1 1 8 .1 7 2 1 5 .7 5 t-S tatis tic -2 .7 8 4 .1 3 -3 .9 8 -3 .2 8 0 .6 7 1 .6 3 -2 .2 5 P ro b . 0 .0 1 0 .0 0 .0 0 .0 0 .5 0 .1 1 0 .0 3

C h o w 's p o o la b ility te st H a u s m a n 's tes t (fix e d x ra n d o m effe cts) H a u s m a n 's tes t (p o o le d x fix e d e ffe cts )

Before moving on to panel data analysis, it should be questioned whether the data set can be pooled into both dimensions spatial and temporal. We then conducted Chows poolability test, whose statistics (0.0055) show that such pooling is possible. The next step is then to choose one of the possible models for aleatory error. The most commonly used hypotheses lead to simple pooling, fixed effects and random effects models. Random effects presupposes that sample observations be aleatory within a given population. However, this is not a reasonable hypothesis when, as in this case, the object of study is a fixed set of insurance companies sampled year by year and within a specific domestic market. Thus, we chose the fixed effects model. It should be noted, however, that the statistical value of Hausmans test (18.17) to guide decisions between fixed or random effects equally justifies both32. An analogous test was used to help decide between fixed effects and simple pooling. The statistics of this test (215.75) rejected the latter model. In Annex III, we present the regressions that use simple pooling and random effect models. The regression presented in Table 3 had adequate explanatory power (R-squared adjusted to 96%) and the set of variables is significantly different from zero, as per F-statistic. When focusing on a four-year period (2001-2004), it makes no sense to investigate occasion serial autocorrelation problems. Nevertheless, heteroskedasticity problems may occur, especially as concerns the significant differences between insurers that constitute the domestic insurance market. Thus, equation (2) was estimated according to Whites consistent
32

Statistics of the referred Hausmans test show a distribution with n-1 degree of freedom, n being the number of parameters to be estimated. A low statistics number indicates that the non-observed effects (heterogeneous) are distributed independently of the explicative variables of the X matrix.

29

covariance method (rather than the standard minimum squares) to lead to consistent error patterns. The coefficient of the variable life shows a negative sign and is statistically different from zero when lower than 0.1% of significance, as predicted by theory and assessed in both time series and cross-section analysis The coefficient of the variable company size evolved to positive and significant (rather than negative and indifferent from zero in cross-section regressions), thus ratifying the time series regression, but contrary to what was predicted by theory. The coefficient of the variable leverage remained negative but turned to significantly different from zero to 0.6%., contrary to what was predicted by theory and found in the time series analysis and in foreign studies. As for the variable market share, the above findings were confirmed: negative and statistically different from zero effect over the demand for reinsurance, as predicted by theory. The variable foreign capital had no statistically different from zero effect upon the demand for reinsurance. Tax rating showed a positive but statistically different from zero coefficient of only 11% of significance. Inversion return rate showed a negative but statistically different from zero coefficient of only 3% of significance, as predicted by theory. Therefore, except for the variable leverage, the other results are consistent with theory or with empirical evidence about demand for reinsurance. In short, regarding such variables, both positive and negative impacts of market share and inversion return rate upon the demand for reinsurance are evident, as predicted by theory. The same applies to concentration on home insurance. Less robust results were collected about the effect of tax rating. The variables geographic concentration and ownership/banking structure do not seem to have any impact on the demand for reinsurance.
Table 7: Demand for Reinsurance Compared Findings Demand for Reinsurance Temporal Series Reinsurance price Leverage Cross-Section Panel Analysis

Vida
Coefficient of Market Penetration Size IRBs liabilities/net equity/ Level of Competitiveness Market Share Tax rating Foreign Capital Return on Investment Rate. Geographic Concentration Ownership Structure (banking) Concentration of Home Insurance

Tempo ( - )** ( + )** ( - )** ( - )** ( + )** ( + )** ( + )** 0

Probable average.

( - )* ( - )** 0 0 0 0 0 0 0 ( - )**

( - )** ( - )** ( + )** ( - )* * ( + )* 0 ( - )* *

( + ) positive coefficient; ( - ) negative coefficient (**) significant at lower than 5%; (*) significant between 5 and 10%; 0 = not significant

On the other hand, the present study was important to assess the validity of the effects of the variables included in the time series analysis - leverage, concentration on life and auto insurance, company size and foreign capital. The coefficients of the variable life showed 30

negative and statistically different from zero signs, as predicted by theory and found by the time series analysis. That means that the higher the concentration on these types of insurance the lower the demand for reinsurance. The coefficients of the variable leverage showed negative and significant signs in both cross-section regressions and panel data analysis. This is contrary to what is predicted by theory and found in the time series analysis. As a rule, we should expect that higher leverage, leading to higher risks, would generate more demand for reinsurance. As for the variable company size, the panel data analysis ratified the positive and significant effect upon the demand for reinsurance, also found in the time series analysis, but contrary to what is predicted by theory. As for foreign capital, the findings of the present study confirm little effect on the demand for reinsurance as found in the time series analysis. Table 7 below summarizes these findings. V. Reinsurance and Insurance Supply Our next step was to estimate the effect of reinsurance operations upon the direct insurance market. However, one should first fully understand the function of reinsurance in producing insurance services. The demand for reinsurance derives from the demand for insurance. Besides the aforementioned factors that refer to risk management and the insurers equity, reinsurance can also be viewed as a type of production factor (added capital) in the supply of insurance services, however not critical to the production of a finite volume of insurance services. In other words, if a given insurer demands zero reinsurance, this insurers production of insurance services will be reduced, but it does not become unfeasible nor does it require an infinite amount of the other production factors (capital, land, and labor). In academic terms, the isoquantum of the insurer allows for a corner solution in which, if the use of reinsurance is zero, production will still be positive and the use of the other factors is finite (see Annex IV). Such view of reinsurance is ratified by Shah and Hole (2004): risk transfer [allowed by reinsurance] changes the risk profile of the insurers flow of revenues. More specifically, it can reduce the frequency and severity of extreme loss scenarios that are at the tail of the net profit distribution. The distribution tail dictates the amount of capital required for keeping within solvency standards - both internal and external ones. The lower probability of extreme losses [allowed by the reinsurer] reduces the amount of capital to be kept in balance by the underwriter. They add that: Conversely, the reinsurer keeps additional capital in its balance to cope with the additional risk now undertaken (presumably, the reinsurer can diversify risk better and shall need less additional capital). In essence, the underwriter will reduce the required capital by loaning additional capital that is recorded in the reinsurers balance sheet. Reinsurance costs are, therefore, also the costs of loaning capital. 33
33

Shah e Hole (2004), p.2. Assignement from the original textbook. The risk transfer [allowed by reinsurance] changes the risk profile of the income stream for the insurer. Specifically, it can reduce the frequency and severity of extreme loss scenarios that are depicted in the tail of the distribution of net income. The tail of the distribution dictates the amount of capital the insurance company will need to meet its solvency targets both internal and externalThe reduction in likelihood of extreme losses lowers the amount of capital required to be held on the balance sheet by the ceding company. They also maintain that: Conversely, the reinsurer holds additional capital on its balance sheet for the additional risk it now assumes (presumably the reinsurer can better diversify the risk and will need less additional capital). In essence, the ceding company is reducing the capital required on its balance sheet by instead renting capital that is on the reinsurers balance sheet. The cost of reinsurance is therefore also the cost of renting capital.

31

In Brazil, there is another peculiarity concerning the reinsurer, a state monopoly in the supply of this factor. Private monopolies usually spoliate their clients, whereas state monopolies are naturally more regulated; nonetheless, their level of fairness as concerns the supply of a good or service is more an empirical than a theoretical issue. Typically, the effect of a monopoly in the supply of a given factor is a higher price of such factor when compared to the expected price if there were market competition and also, depending on final demand elasticity, the increase in price is passed on to consumers. Consequently, one can expect that: (1) ceteris paribus, the insurers profit margin is pressed downwards because this monopoly-controlled factor has a higher cost to them; and (2) concerning market equilibrium, once there is normal elasticity demand for prices (in the case of insurance and mainly of insurance renewals), this price is higher and the volume of insurance services traded is lower in a relative proportion to what would happen in a market where the supply of the reinsurance factor were competitive34 (see Annex V). In sum, the next step was to estimate the aggregate supply of direct insurance that holds, among its arguments, the aggregate volume of reinsurance. Our starting point was a time series analysis. Estimating this supply is even more difficult than estimating reinsurance demand. Within the investigated period of time (1970-2004), there is not a complete series of data for the production factors labor and land that apply to the insurance industry. As concerns capital, there is statistics about the insurers aggregate net equity (their own capital), reserves and their reinsurance operations, but none about loan capital or human capital. Therefore, if we follow the principle that some data is better than no data at all, we can estimate regression using the following equation:

PREM / PL = + ( DRSSL / PL) + COMPET1 + AR(1)

(5)

where PREM/PL is the ratio between volume of issued insurance policies/insurers aggregate net equity, DRSSL/PL is the ratio between net demand for reinsurance/ insurers aggregate net equity, COMPET1 is a dummy variable that seeks to represent the changes in the insurance market since the 1990s opening-up35, that being 0 (zero) from 1970 to 1989 and 1 (one) from 1990 to 2004, and AR(1) a first-order autoregressive term. The former variable aims to approximate the quotient product/mean capital of the insurance market while the latter the quotient between the reinsurance production factors/capital. The expected correlation between both is positive. Obviously, this being a production function, we should ideally use an amount of goods and their production factors, not their volumes. Unfortunately, the lack of deflators leads us to use volumes36 instead of amounts and net equity sums. The regression results are shown in Table 8 below.

34

Hirshleifer (1976), pp. 393-396, Vasconcellos e Oliveira (2000), pp.221-230; and Varian (1978), p.52-55.

35 36

For more on this, see Faria (2005), p. 42. As far as reinsurance is concerned, we could use IRBs retained claims plus the variation in their reserves as the proxy for amounts, as mentioned above. But we suspect this would complicate the model without, however, adding to the explicative power, given the gaps in the other variables.

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TABLE 8 Production of Direct Insurance Temporal Series Dependent Variable: PREM/PL Method: Least Squares Sample(adjusted): 1971 2004 Included observations: 34 after adjusting endpoints Convergence achieved after 7 iterations Variable C RSSL/PL COMPET1 AR(1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 0.78 3.44 0.68 0.73 0.92 0.92 0.18 0.96 12.45 2.13 Std. Error 0.17 0.54 0.16 0.08 t-Statistic 4.57 6.34 4.26 9.21 Prob. 0.0 0.0 0.0 0.0 1.81 0.61 -0.5 -0.32 119.71 0.0

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

Inverted AR Roots .73 Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 0.23 0.27 Probability Probability 0.63 0.60

The regression shows an adequate explanatory power. The 92.3% R squared is high, all the explicative variables coefficients are statistically different from zero at low levels of significance, and residue serial correlation tests and heteroskedasticity tests do not indicate the existence of such problems. The signs found are those predicted by theory, that is, the ratio between the issued insurance premiums/insurers net equity (our proxy for the quotient product/capital) has a positive correlation with the ratio between net reinsurance/insurers net equity (the proxy for reinsurance/capital) and with the high level variable that measures the insurance industry competition. The first-order autoregressive term [AR(1)] was inserted in the regression a posteriori to improve the adjustment of the curve. As the volume of reinsurance shows high positive correlation with the volume of direct insurance, we conducted Grangers test so as to verify causality direction. Our hypothesis, based on the discussion above, is that there is a reciprocal causality relationship that is stronger along the axis of direct insurance towards reinsurance. Table 9 below shows that a Grangers test using equation (5) variables and the four-year imbalance should support our suppositions, given the low probabilities of the statistic of this test.

33

TABLE 9: Reinsurance Causality > Direct Insurance Pairwise Granger Causality Tests Sample: 1970 2004 Lags: 4 Null Hypothesis: RSSLPL does not Granger Cause PREMPL PREMPL does not Granger Cause RSSLPL COMPET1 does not Granger Cause PREMPL PREMPL does not Granger Cause COMPET1 COMPET1 does not Granger Cause RSSLPL RSSLPL does not Granger Cause COMPET1 Obs 30 30 30 F-Statistic 2.96 4.77 0.66 1.67 0.58 2.17 Probability 0.04 0.01 0.63 0.19 0.68 0.11

As in demand for insurance, we estimated the effect of reinsurance operations upon the sales of direct insurance services through cross-section and panel data analysis regressions, aiming to estimate direct insurance supply at corporate level, which holds among its arguments the respective volume of reinsurance. The estimated equation was the following:

ps = + .res + . cos s + .cap + .dadm + .dcom + .atv

(6)

The Greek letters represent the parameters to be estimated. The abbreviations, in the specific order and per company, refer to the ratio between direct insurance premiums, retained claims nets, plus investment revenues/total assets (ps), paid reinsurance premiums, accepted retrocessions nets/total assets (res), paid coinsurance premiums, accepted coinsurance nets/total assets (coss), net equity/total assets (cap), administrative costs/total assets (dadm), and brokearage costs/total assets(dcom). The latter variable (atv) refers to the absolute value of the total assets. A production function should relate the produced amounts of a given good or service to the amounts of used production factors. However simple this proposition might be, it casts a veil over several problems that arise when it is used in empirical investigation. Firstly, the concept of an insurers product is subject to controversy. Some authors contend that, being the responsibility of the insurer to protect the insured against specific events, its product should be estimated through the following formula: gained premiums plus investment revenues minus retained claims, all this deflated by a policy price index37. Other authors claim that the above formula, for being tautologically equal to administrative and brokerage expenses plus profit focuses more on the industrys actions to keep its ability to pool risks than on the product itself. For these authors, an insurers product is related to the amount of risk it can take up and not to the activities that allow for such risk taking. Therefore, product is more appropriately described by the real amount of the sum: gained premiums plus investment revenues. Along the same line, other authors still claim that product is better measured by the sum of the retained claims plus additions to reserves, arguing that this is a service rendered to society (insureds and shareholders) by the insurers. In equation (3) we used the former concept, carefully replacing gained premiums with direct insurance
37

This is the definition recommended by the OECD (Organization for Economic Cooperation and Development). See Lequiller, F., moderator (2003) OECD Task Force on the Measurement of Non-life Insurance Production in the context of Catastrophes, Final Report.

34

and placing the premiums derived from reinsurance and coinsurance at the right end of the equation. The reason for doing so is that these are the variables we are actually concerned with. A second problem concerns deflating the product likewise measured. As we are operating at corporate level, a price index per company would be ideal, but this is a remote possibility especially because the market as a whole still lacks a comprehensive insurance price index. The variables res, coss, cap, dadm e dcom aim to approximate the consumption of the production factors capital and labor, though it should be noted that we have subdivided capital into capital itself, reinsurance and coinsurance38. By doing so we assume that net equity can be an approximation to capital at strictly corporate level and that the insurers expenses equal the consumption of production factors. As concerns brokearge and administrative costs, such hypothesis does not betray reality, since the gross value of these variables refers to expenses with human resources both internally (employees) and externally (agents and brokers). Finally, the variables that express product and consumption of production factors were normalized by total assets, so that by including total assets as an explicative variable at the right end of the equation we aim to capture occasional scale effects upon production. Table 10 below shows the results of the estimation process through cross-section analysis for the years 2001-2004.
Table 10. Reinsurance and the Production of Insurance (cross-section analysis)
Dependent Variable: PS Method: Least Squares Sample(adjusted): 1 61 Included observations: 61 after adjusting endpoints White Heteroskedasticity-Consistent Standard Errors & Covariance (except for 2004 regr.) 2001 2002 2003 Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic Variable C RES COSS CAP DADM DCOM ATV R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) 12.62 0.12 0.08 0.36 1.04 0.25 0.00 0.60 0.56 20.84 23446.26 -268.08 2.35 51.87 31.26 9.02 9.26 13.51 0.00 1.86 5.72 3.28 2.04 2.63 0.66 -1.66 13.70 0.13 0.09 0.36 0.78 0.47 0.00 0.80 0.78 16.44 14586.41 -253.60 2.06 58.28 34.67 8.54 8.79 35.51 0.00 2.44 10.49 6.44 2.09 3.04 1.74 -0.92 22.95 0,12 0.09 0.09 0.77 0.59 0.00 0.79 0.77 16.17 14118.37 -252.61 2.23 59.18 33.52 8.51 8.75 33.99 0.00 4.05 9.35 13.02 0.66 2,67 1.88 -1.53

2004 Coefficient t-Statistic 27.98 0.08 0.09 -0.24 0.28 2.12 0.00 0.51 0.46 33.31 59924.57 -296.70 2.04 70.20 45.29 9.96 10.20 9.48 0,00 2.12 3.38 2.42 -0.73 0.61 4.35 0.44

The regressions that refer to 2001, 2002 and 2003 show some traits of heteroskedasticity and therefore were estimated through Whites consistent covariance method (rather than standard minimum squares) so that we could obtain consistent error patterns. Except for

The lack of data prevented us from including any proxy for the consumption of the factors land and human capital.

38

35

2004, the regression show adequate explanatory power, considering that the R-squared were adjusted to +50%. The set of explicative variables is significantly different from zero, as per F-statistic. The coefficients for reinsurance e coinsurance show the expected positive signs and are statistically different from zero at extremely low levels of significance, as per the time series regression. That means that the higher the use of reinsurance and/or coinsurance the bigger the insurers product (according to the chosen measurement). The coefficients of the variable capital were found to be positives and significant, as expected, but only in 2001 e 2002. The coefficients of the two variables that approximate the factor labor administrative and marketing costs indicate positive and significant impact on some of the years, but not in others, and thus cannot be considered conclusive. As concerns the variable total assets, whose inclusion aims to measure scale effects, the coefficients were indifferent from zero in the four years, which leads us to conclude the absence of such effects. As aforementioned, the estimated coefficients in cross-section analysis might be biased, given certain heterogeneities not assessed between the various components of the set of data. This problem can be correct by means of panel data studies, that is, regression analyses with both dimensions - spatial and temporal. Thus, we have re-estimated equation (6) likewise and the results are shown in Table 11 below.
Table 11: Reinsurance and Insurance Supply (panel analysis)

Dependent Variable: PS Method: Pooled Least Squares (fixed effects)

White Heteroskedasticity-Consistent Standard Errors & Covariance

Sample: 2001 2004 Included observations: 4 Number of cross-sections used: 61 Total panel (balanced) observations: 244
Variable RES COSS CAP DADM DCOM ATV Coefficient 0.14 0.09 -0.4 0.39 1.67 1,07E-06 0.77 0.68 20.89 116.64 0.0 59.88 36.96 77273.7 1.94 t-Statistic 7.62 4.51 -1.26 0.76 2.4 2.98 Prob. 0.0 0,0 0.21 0.45 0.02 0.0

R-squared Adjusted R-squared S.E. of regression F-statistic Prob(F-statistic) Mean dependent var S.D. dependent var Sum squared resid Durbin-Watson stat

For the same reasons aforementioned, we chose fixed effects to cater for the aleatory error of equation (6). Random effects presupposes that sample observations be aleatory within a given population. However, this is not a reasonable hypothesis when, as in this case, the object of study is a fixed set of insurers within a specific domestic market. Considering 36

possible heteroskedasticity problems, the equation was estimated according to Whites consistent covariance method so as to reach consistent error patterns. The regression shows adequate explanatory power as per the R-squared values and the F-statistic. The coefficients of variables reinsurance and coinsurances are positive and highly significant, as expected and verified by the cross-section and time series analyses. The variable brokerage costs also shows positive and significantly different from zero effect, but the same did not occur for the variables capital and administrative costs. The coefficient of variable assets was found to be positive and significantly different from zero, therefore showing that scale effects upon the insurers product make the latter increase at a higher rate than the rate of company expansion. In sum, as concerns the production function of insurance, cross-section and panel data regressions have validated the findings of the time series analysis. The coefficients of variables reinsurance and coinsurances were positive and highly significant, as expected, just as were the coefficients for the variable brokerage costs. However, the variables capital and administrative costs did not show significant effects on insurance supply. The coefficient of variable assets, positive and significantly different from zero, indicated the existence of scale effects on the insurers product. Table 12 shows these results.
Table 12: Production of Insurance Compared Results

Production of Insurance
Time series Cross-section analysis Probab. median Panel data analysis

(+)** (+)** (+)** Reinsurance (+)** (+)** Coinsurance 0 0 Capital (+)* 0 Administrative Costs 0 (+)** Marketing Costs 0 (+)** Assets (+)** Level of Competition (+) positive coefficient; (-) negative coefficient (+)** significant at lower than 5%; (*) significant between 5 and 10%; 0 = non-significant

VI. Opening of Reinsurance Market - Projections: Time series regressions allow us to project what would occur in the direct reinsurance and insurance market if the reinsurance market opened up to competition. The findings, unfortunately, could not be validated by the cross-section and panel data analysis, given the impossibility of including supply of supplementary services. We also noted that as the study is based on the projection of earlier relationships, it is not able to capture certain probable changes in market structure and in insurers production function that would follow the opening of the reinsurance market39. Thus, time series analyses define a synthetic model of the reinsurance market that incorporates the direct insurance market. The model is composed of equations (2) and (5), being the former the demand for reinsurance and the latter the insurance supply in which we

39

It would be naive to view such projections as predictions for the future. They are, in fact, only past projections towards the future, or, more precisely, "counterfactual" variations of real past situations.

37

suppose that insurers use, besides their own capital and traditional production factors, the reinsurance transactions. The model is, therefore, a system composed of two equations, two endogenous variables (reinsurance net demand), DRSSL, and issued insurance premiums, PREM), besides seven exogenous variables (PRESS, PL, PIB, number of insurers, VIDA, PASS and COMPET). The model equations were estimated separately, but in Annex VI we show a simultaneous estimation by means of "seemingly unrelated regression , in which it becomes evident that the coefficients and their statistical significances do not vary much from the previously reported results. Our objective is to estimate the extent to which demand for reinsurance and insurance supply would vary if there were the actual opening up of the reinsurance market, that is, in case IRB lost its monopoly status in this sector. We conducted what could be termed as a counterfactual projection aiming to estimate what would have occurred regarding the demand for reinsurance in the period between 2005 and 2007 if, in early 2005, the reinsurance market had indeed opened up. This meant projecting the set of exogenous variables in time. Let us start with those variables that would be more typically affected by such market opening, that is, those that specifically relate to IRB, such as the average insurance price index and the quotient between interest bearing liabilities/net equity. We also supposed that there would be ample market opening, that possible remaining restrictions would be those ordinarily found in organized and properly regulated competitive markets. It should be clear that such projection, by logical fatality, if extrapolated towards the future, sheds light only over short-term changes in the reinsurance market40. To estimate reinsurance average price index variations, as per the proxy used in our study, we calculated the same variable for a sample of five big international reinsurers over the period 1999-2004 which, as per a Swiss Res report, accounted for approximately 1/3 of the global reinsurance market revenues. This was the benchmark for the average reinsurance price to be established in Brazil in the short term in case IRB actually loses the monopoly and competitive conditions are established in the domestic market. The results shown in Table 13 below indicate that the mean reinsurance price between 1999 and 2004 was 1.46 for IRB against only 0.90 for the sample of international reinsurers, being this mean value weighed by gross premiums. In 2004, such values were, respectively, 1.88 and 0.89, which points to the alleged fact that in Brazil, reinsurance price is on average higher than overseas. It becomes clear that price dispersion should increase if IRB loses the reinsurance monopoly and so, smaller and less organized insurers will possibly pay higher reinsurance prices. The opposite shall happen with the bigger and better organized insurers. However, on average terms, it is highly improbable that the opening up of the reinsurance market (in fact, of any monopolist market) has zero or an upward impact upon prices. What tells a monopoly company from a competitive company is precisely the ability of the former to impose higher prices to consumers, which becomes difficult for the latter. Let us suppose, then, that the opening up of the reinsurance market, enabling the free access of domestic insurers to the global reinsurance market and the subsequent competition, would cause a fall in the current average

40

Longer term projections would bear the advantage of anticipation, but the disadvantage of the complexity derived from the inevitable imposition of several ad hoc hypotheses subject to dynamic adjustment.

38

price index from the current 1.88 mean value charged by IRB (or the 1.46 between 19992004) to 1.6 in 2005, 1.3 in 2006, and 1.0 in 200741.

Table 13: Reinsurance Price Indicators of Selected Companies 1999 2000 2001 2002 IRB Retained Premiums 661 660 800 1086 Brokerage expenses 50 47 57 92 Retained Claims 565 556 517 778 Reserves Variation 2.4 30 50 77 Reinsurance Price Index 1.08 1.05 1.31 1.16 Munich Re General Re Swiss Re Hanover Re Scor Weighed average* 0.75 0.89 0.93 0.97 0.94 0.86 0.73 0.95 0.89 0.93 0.82 0.85 0.73 0.70 0.82 0.91 0.78 0.77 0.89 0.89 0.94 1.01 0.86 0.92

2003 1267 114 493 18 2.26 0.89 1.16 1.00 1.01 0.83 0.98

2004 1429 132 654 35 1.88 0.88 n/a 1.00 0.98 1.03 0.95

Sources: Balance Sheets available on the Internet. (*) weights: gross premiums in 1997

We used the same demarche for the quotient between IRBs interest bearing liabilities/net equity, which measures the supply capability and then compared IRBs variable against the same variable for the aforementioned group of international reinsurers. The results in Table 14 show that on average, between 1999 and 2004, for the group of international reinsurers, this quotient was 8.8 while for IRB this value drops to 2.2. In 2004, the respective mean values were 9.2 and 2.2. We believe that, if on the one hand IRBs low leverage grants them solvency, on the other hand it reduces their supply capability. Thus, we suppose that with the opening of the market, the domestic insurers would gain access to the international reinsurance market and, analogously, local reinsurers, both current and occasional companies, would face international market contestability. And so, the insurers perception of the referred variable, established by the group of domestic reinsures and especially by international reinsurers, would rise to a 3.5 mean in 2005, 5.0 in 2006, and 7.0 in 2007. We kept the same number of insurers (114) operating in Brazil between 2005 and 2007. Although this is an optimist hypothesis - given certain insurers high level of dependence on state reinsurance and their subsequent difficulty to survive in an open reinsurance market it has been adopted because we can hardly estimate the number of companies that will remain in the market and also because we suspect the variable TAM (penetration coefficient divided by the number of companies) might capture unknown additional factors that would yield a biased coefficient in equation (2). Wee also kept as 1 (one) the dummy COMPET, thus indicating the same competitive conditions in the insurance market and in the economy as a whole. In fact, such conditions tend to improve with the opening up of the reinsurance market, but as they were captured in our model by a binary variable, there is no way we can possibly adjust them upward. Anyway, this is a conservative demarche concerning what may occur in the post-opening reinsurance and insurance markets. As to the share of the collected life, health and auto premiums in total premiums, we have established it at 76% and
Another issue is how such reduction would occur: the price of a good or service may fall due to a) a reduction in its monetary value per unit, b) an increase in supply if the batch price is kept the same, c) supply of a similar product of better quality or of equal price but lower quality, or still a combinations of the previous options.
41

39

we believe such hypothesis does not violate reality given the recent trend of slower growth. As concerns GDP and the insurers net equity, we suppose that both would grow at a real 3.5% annual rate between 2005 and 2007.
Table 14: Ratio Between the Selected Reinsurers Required Liability/Net Equity

Required Liability (A) Net Equity (B) A/B Munich Re General Re Swiss Re Hanover Re Scor Weighed average *

1999 1671 763 2.2 8.7 4.5 4.2 14.7 6.0 7.1

2000 1593 801 2.0 7.2 4.3 5.3 13,9 8.2 6.9

2001 1979 912 2.2 9.4 6,3 6.5 18.5 11.9 9.1

2002 2756 1095 2.5 13,1 5.1 8.7 18.3 13.9 11.0

2003 2679 1209 2.2 10,1 6.5 8.2 12,7 21.5 9.9

2004 3007 1379 2.2 9.6 na 8.6 12.8 9.1 9.6

Sources: Balance Sheets available on the Internet. (*) weights: gross premiums in 1997

Additionally, as a consequence of the expected fall in reinsurance prices and of better supply conditions following the opening up of the reinsurance market, a reversion of the currently co-insured amounts towards reinsurance is expected. In Brazil, insurers have chosen coinsurance as a cheaper and more agile alternative for risk coverage than the alternative supplied by IRB. But the fall in prices would lead companies to choose reinsurance, following the international trend. It should be noted that the share of coinsurance in total issued premiums has fallen from 6.4% in 1999 to 2.8% in the first half of 2005, as a consequence of foreign companies reticence in participating in coinsurance pools. Our hypothesis is that the open reinsurance market would capture all the coinsurance transactions, at 2.8% of the premiums issued between 2005 and 2007. We can then move on to projecting the system that comprises equations (2) and (5) for the years 2005-2007. The software E-Views does that using an interactive algorhythm known as Gauss-Seidels method 42. Table 15 show the insurance and reinsurance markets for the period 2005-2007.

According to E-Views, Gauss-Seidels algorhythm evaluates each equation in the order it comes in the model and uses the new value of the endogenous variable as the value that comes up in any other equation.

42

40

Table 15: Impacts of Opening up the Reinsurance Market actual. projected 2004 2005 2006 1. Reinsurance Demand* 2,839 3,299 4,849 2. Coinsurance 1,128 3. Coinsurance Reversion* 1,366 1,531 4. Reinsurance (Total)* 2,839 4,665 6,380 5. Reinsurance /Insurance Premiums 6.3 9.9 12.0 6. Reinsurance / GDP 0.16 0.25 0.34 (%)

2007 6,993 1,764 8,757 14.3 0.45

208.5 126.4 181.3

Percent additions in (4) Percent additions in (5) Percent additions in (6)

(*) in million R$ in 2004

64.3 57,0 56.3

124.7 90.5 112.5

7. Issued Insurance Premiums* 8. Insurance premiums / GDP (%) Percent additions in (7) Percent additions in (8)
(*)in million R$ in 2004

45,101 2.55

47,161 2,58 4.6 1.2

53,161 2.82 17.9 10.6

61,403 3.13 36.1 22.7

The table clearly shows that the opening of the reinsurance market is favorable not only for this market itself but also for the direct insurance market. The counterfactual projection we conducted shows the demand reinsurance would rise from R$2,839 million in 2004 to R$6,993 million in 2007 and, when adding the migration of coinsurance transactions to the reinsurance market, the total sum would be R$8,757 million in 2007, thus standing for a 208.5% increase over 2004. As a ration of the issued premiums, the demand would leap 126.4% - from 6.3%in 2004 to 14.3% in 2007. The mean value in relation to GDP would increase from 0.16% to 0,45% within the same period. As concerns the direct insurance market, the opening up of the reinsurance market would lead to a 36.1% rise in supply, from R$45,101 million in 2004,= to R$61,403 million in 2007, focused primarily on issued premiums. As for GDP (penetration coefficient), the market would increase its earnings from 2.55% to 3.,13% within the same period. It should be noted that these are central projection points and that the projection significance is within a 95.4% trust margin regarding reinsurance, and around 18% insurance premiums, within in a variable 10% margin of these central points. The graphs below illustrate the evolution in time of the variable liquid demand for reinsurance as a percentage of issued insurance premiums, assessed (DRSS) and predicted with and without coinsurance reversion (DRSSF), and of the variable insurance premiums as a percentage of GDP, also assessed (PENT) and predicted (PENTF) by the model for 1970 to 2007.

41

Demand for Reinsurance

18

16

14

12

10

4
70
75
DRSS

80

85

90

95

00

05

DRSSproj.

DRSSp+Rev .COSS.

Insurance Penetration Coefficient

3.5

3.0

2.5

2.0

1.5

1.0

0.5
70
75
80
85
PENT
VII. Conclusions: We examined the Brazilian demand for reinsurance and the impact of reinsurance operations in the direct insurance market through time series, cross-section and panel data analyses. The ultimate objective of this study was to measure the extent to which the respective 42

90

95
PENTF

00

05

markets would be affected for the apparently inevitable opening up of reinsurance and consequent extinction of IRBs monopoly in this market sector. To achieve this goal, reinsurance was investigated in both theoretical and empirical planes. We observed that, theoretically, at a corporate level, the demand for reinsurance can be viewed as a function of tax rating, ownership structure, leverage, credit rating, company size, concentration upon specific business lines, tail, correlation between inversion return and claims costs, and the profitability of assets.. As concerns aggregate demand for reinsurance (countries), certain variables should be added like market scale, the countrys financial development, as well as other variables that are able to capture the impacts of noncompetitive markets, the existence of compulsory local reinsurers, and legal restrictions to foreign companies operations. Foreign empirical studies referred to estimate this demand by means of cross sections or panel data analyses of sets of companies that operate in domestic markets or sets of countries. The variables leverage, company size, business lines, geographic concentration, market scale, financial development, and the dummy variables for non-competitive markets plus restrictions to foreign companies were, overall, found to be significant in the regression analyses herein presented. On the other hand, such studies notably did not investigate such variables like reinsurance price and efficiency gains from supplementary services, considered of importance in determining the demand for reinsurance. Regarding the Brazilian scenario, we examined the demand for reinsurance through a time series analysis of the period between 1970 and 2004. With the available data, we assess this demand to have performed as predicted by economic theory in what refers to the issue in question, that is, reinsurance price, insurance penetration coefficient, and the concentration on life, health and auto insurance business had negative effects upon reinsurance operations while leverage, the ratio between IRBs net equity and market competition showed positive effects. The only exception was the variable company size, which had a positive significant sign in regression indicating that, ceteris paribus, Brazilian insurers growth called for a higher demand for reinsurance. We verified these findings by means of statistical cross-section regressions upon a sample set of 61 insurance groups that operated in the domestic market between 2001 and 2004. Additionally, pooling such data in time enabled us to conduct panel data analyses, that is, temporal cross-section regressions that bear the advantage of maximizing statistic estimation of the available set of data. The equations estimated as per these techniques allowed us to study the effects of variables that, either due to logical fatality or to the lack of aggregate data, had not been previously verified: market share, tax rating, inversion return rate, geographic concentration, ownership structure/banks and concentration on home insurances (applied to the issue of demand for reinsurance), as well as the variables coinsurance, capital, administrative expenses, brokerage expenses and assets (applied to the relationship between the insurers product and the consumption of reinsurance). In conclusion, it is clear that the variables life, market share, and investment return rate have negative and significant effects pm the demand for reinsurance, as predicted in 43

theory. The same occurs with concentration on home insurance. As concerns the variable company size, the panel data analysis ratified the positive and significant effect on the demand for reinsurance as assessed by the time series analysis, which goes against what is predicted in theory. As for foreign capital, the findings of the present study confirm its little effect on the demand for reinsurance. However, regarding tax rating and leverage, the results are questionable. In the time series analysis, leverage showed a positive and significant effect upon the demand for reinsurance, as predicted by theory; however, the opposite effect (a negative and significant sign) was found in the cross-section and panel data regressions. The variables geographic concentration and ownership structure/banks did not seem to affect the demand for reinsurance. It was also noted that reinsurance may be viewed as some additional capital (or additional solvency margin) to the insurance market and thus, as one of its production factors. The estimation of the insurance supply equation considering this characteristic yielded results as predicted in theory: positive effect of reinsurance upon direct insurance. Thus, reinsurance and coinsurance consumption coefficients were positive and highly significant regarding the production of insurance. The variable brokerage expenses had a positive while less significant effect. But the variables capital and administrative expenses did not show significant effects on insurance supply. The coefficient of the variable assets was positive and significantly different from zero, thus indicating positive scale effects upon the insurers product. In other words, insurance production has increased at a higher rate than company growth. The statistically estimated equations defined a model that allowed us to project the demand for reinsurance and insurance supply between 2005 and 2007 in an open reinsurance market and as a function of a given number of exogenous variables. Of critical value in our projection were the hypotheses that, with the opening up of the market, reinsurance price would drastically fall but the reverse would occur with IRBs net equity, having as a proxy IRBs ability to supply insurers with supplementary services. Using numeric calculation, this model shows highly positive impacts of the opening up of reinsurance both on this market and upon the direct insurance market, synthesized by a demand for reinsurance that would grow more than 200% in three years and by the insurers ability to increase by 36% their earnings with insurance premiums within the same period if all the aforementioned conditions remained constant. It should be noted that two shortcomings of the present study were the impossibility to include coinsurance price variables in the regressions, and to validate future projections produced by time series regressions through cross-section and/or panel data analyses. Finally, it is worth mentioning that, as this prediction exercise bases itself on future extrapolations of past quantitative relationships, it cannot capture beneficial impacts derived from changes in the insurance market structure that would follow the opening up of reinsurance. Among such impacts it is worth mentioning: a) gains with the expected increase in product supply: the monopolist market has hindered IRBs expansion into insurance businesses that show high growth potential (life, health and social security, financial risks, government risks, etc) while such is not the case of international reinsurers, which supply a wide array of products and support insurers to do the same in selling direct insurance; b) 44

scale gains derived from the new open market: there will probably be an increase in the mean value for company average size that shall yield positive effects upon the volume of insurance supply, as empirically assessed by this study. Additionally, in consonance with the strictest foreign reinsurance market standards, local insurers will be forced to improve their administrative and governance practices in ways that benefit consumers and the market as a whole; c) gains derived from improved underwriting practices in the post-opening reinsurance market: global reinsurers are not only qualified to design new products but also highly aware of market features, since they hold extensive time and space databases about insurances events. This allows them to better quantify risks and improve their underwriting practices. Local insurers shall gain access to such expertise and this will greatly aid them to correctly price insurance policies and to increase their efficiency regarding claim indemnization procedures.

November 2006

45

Annex I: The regression below refers to equation (1). The coefficients for variables KEST, DESFIN and JUROSR were, from the start, statistically indifferent from zero. Later tests showed that the same occurred with variables PLIR and DAIR coefficients. These five variables have, therefore, been discarded and not included in equation (2).
Dependent Variable: DRSS Method: Minimum Squares Sample: 1970 2004 Included observations: 35 Variable Coefficient Standard Error 7.42 0.90 0.95 2.76 273.35 0.13 2.46 0.61 0.08 0.10 0.04 0.16 0.03 t-statistic Probab.

C PRSS ALVMER PENT TAM VIDA COMPET PASS KEST DESFIN DAIR PLIR JUROSR R-squared Adjusted R-squared SE of regression. Sum squared resid Log likelihood Durbin-Watson statistic

4.20 -0.18 1.78 -11.49 1261.99 -0.18 5.10 1.41 -0.09 0.15 0.07 0.14 0.01 0.91 0.86 1.46 47.12 -54.87 2.15

0.57 -0.20 1.88 -4.16 4.62 -1.36 2.07 2.33 -1.12 1.57 1.79 0.85 0.23

0.58 0.85 0.07 0.00 0.00 0.19 0.05 0.03 0.28 0.13 0.09 0.40 0.82 9.69 3.94 3.88 4.46 18.74 0.00

Man dependent variable SDdependent variable Akaike Criterion Schwarz Criterion F statistic Prob (F)

46

Annex II: Conglomerates of Insurance Companies in 2001

CONGLOMERADOS BANCO DO BRASIL BANCO DO BRASIL BANCO DO BRASIL BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO BRADESCO CIGNA CIGNA CIGNA CAIXA ECONMICA CAIXA ECONMICA GENERALI GENERALI HSBC HSBC ICATU ICATU ITA ITA ITA ITA ITA ITA ITA MAPFRE MAPFRE MAPFRE METROPOLITAN METROPOLITAN METROPOLITAN MINAS BRASIL MINAS BRASIL PORTO SEGURO PORTO SEGURO PORTO SEGURO ROYAL ROYAL RURAL RURAL SANTOS SANTOS SANTANDER SANTANDER SANTANDER SULINA SULINA SUL AMRICA SUL AMRICA SUL AMRICA SUL AMRICA SUL AMRICA TOKIO TOKIO UBF UBF UNIBANCO UNIBANCO UNIBANCO UNIBANCO UNIBANCO UNIBANCO UNIBANCO NOME BRASILSADE COMPANHIA DE SEGUROS BRASILVECULOS COMPANHIA DE SEGUROS COMPANHIA DE SEGUROS ALIANA DO BRASIL ALVORADA VIDA S/A (Em aprovao) [antiga BBV PREVIDNCIA ATLANTICA - BRADESCO SEGUROS S.A BCN SEGURADORA S.A. BRADESCO SAUDE S.A BRADESCO AUTO/RE CIA DE SEGUROS BRADESCO SEGUROS S.A BRADESCO VIDA E PREVIDNCIA S.A. INDIANA SEGUROS S/A NOVO HAMBURGO CIA. DE SEGUROS GERAIS FINASA SEGURADORA S/A ASSURANT SEGURADORA S/A CIGNA COMPANHIA DE SEGUROS CIGNA SEGURADORA S.A. CAIXA SEGURADORA S/A CAIXA VIDA E PREVIDNCIA S.A. GENERALI DO BRASIL CIA NACIONAL DE SEGUROS SUDAMERIS VIDA E PREV S/A (Em aprovao) [antiga SUDAMERIS CCF BRASIL SEGUROS S/A (HSBC SEGURO SADE S/A) HSBC SEGUROS (BRASIL) S.A. CANADA LIFE PREVIDNCIA E SEGUROS S/A ICATU HARTFORD SEGUROS S/A BANERJ SEGUROS S/A BEMGE SEGURADORA S/A COMPANHIA DE SEGUROS GRALHA AZUL ITA SEGUROS S/A ITA VIDA E PREVIDNCIA S.A. ITAUPREV VIDA E PREVIDNCIA S/A PARANA CIA DE SEGUROS MAPFRE SEGURADORA DE GARANTIAS E CRDITO S/A Mapfre Vera Cruz Seguradora S/A MAPFRE VERA CRUZ VIDA E PREVIDNCIA S.A (Em aprovao) METROPOLITAN LIFE SEGUROS E PREVIDNCIA S/A SEGURADORA SEASUL S.A. SOMA SEGURADORA S/A CIA. SEGUROS MINAS-BRASIL MINAS BRASIL SEGURADORA VIDA E PREVIDNCIA S/A AZUL COMPANHIA DE SEGUROS GERAIS PORTO SEGURO CIA DE SEGUROS GERAIS PORTO SEGURO VIDA E PREVIDNCIA S/A. CGU COMPANHIA DE SEGUROS ROYAL & SUNALLIANCE SEGUROS (BRASIL) S.A INVESTPREV SEGUROS E PREVIDNCIA S/A RURAL SEGURADORA S/A SANTOS CIA DE SEGUROS SANTOS SEGURADORA S.A. MERIDIONAL COMPANHIA DE SEGUROS GERAIS SANTANDER BRASIL SEGUROS S/A SANTANDER SEGUROS S/A APS SEGURADORA S/A SULINA SEGURADORA S/A GERLING SUL AMRICA S.A. SEGUROS INDUSTRIAIS SUL AMRICA AETNA SEGUROS E PREVIDNCIA S/A SUL AMRICA CIA NACIONAL DE SEGUROS SUL AMRICA SANTA CRUZ SEGUROS S/A SUL AMRICA SEGUROS DE VIDA E PREVIDNCIA S/A TOKIO MARINE BRASIL SEGURADORA S/A TOKIO MARINE SEGURADORA S/A (EM APROVAO) [ANTIGA REAL SEGURADORA BRASILEIRA RURAL S/A UBF GARANTIAS & SEGUROS S/A AIG BRASIL COMPANHIA DE SEGUROS AIG BRASIL COMPANHIA DE SEGUROS ( INATIVA) TREVO BANORTE SEGURADORA S/A TREVO SEGURADORA S/A UNIBANCO AIG PREVIDNCIA S/A UNIBANCO AIG SEGUROS S/A UNIBANCO AIG VIDA E PREV. S/A (Em aprovao) [antiga PHENIX SEGUR.

47

Annex II (cont.): Individual Insurers in 2001

INDIVIDUAL INSURERS NAME ACE SEGURADORA S.A. AGF BRASIL SEGUROS S.A. ALFA SEGURADORA S/A (Em aprovao) [antiga ALFA Seguros e Prev. S.A.] AUREA SEGUROS S/A BANESTES SEGUROS S/A CARDIF DO BRASIL SEGUROS E PREVIDENCIA S/A CENTAURO VIDA E PREVIDNCIA S/A (Em aprovao) [antiga CENTAURO CHUBB DO BRASIL CIA DE SEGUROS CIA SEGUROS PREVIDENCIA DO SUL COMBINED SEGUROS BRASIL S/A. COMPANHIA DE SEGUROS ALIANA DA BAHIA COMPANHIA EXCELSIOR DE SEGUROS CONAPP CIA NACIONAL DE SEGUROS CONFIANA CIA DE SEGUROS COSESP - CIA DE SEGUROS DO ESTADO DE SO PAULO FEDERAL DE SEGUROS S/A GENTE SEGURADORA S.A. HDI SEGUROS S/A INTERBRAZIL SEGURADORA S/A J. MALUCELLI SEGURADORA S/A KYOEI DO BRASIL COMPANHIA DE SEGUROS LIBERTY SEGUROS S/A (EM APROVAO) [ANTIGA LIBERTY PAULISTA SEG. MARTIMA SEGUROS S/A MBM SEGURADORA S/A MITSUI SUMITOMO SEGUROS S/A NOBRE SEGURADORA DO BRASIL S/A NOTRE DAME SEGURADORA S/A PANAMERICANA DE SEGUROS S-A PQ SEGUROS S/A (EM APROVAO) [antiga BBM CIA. DE SEGUROS S/A] PRUDENTIAL DO BR SEGUROS DE VIDA S/A QBE BRASIL SEGUROS S/A SABEMI SEGURADORA SA SAFRA VIDA E PREVIDNCIA S/A (Em aprovao) [antiga SAFRA SEG. SANTA CATARINA SEGUROS E PREVIDNCIA S.A SEGURADORA BRASILEIRA DE CRDITO EXPORTAO S/A SEGURADORA ROMA S/A UNIMED SEGURADORA S/A XL INSURANCE (BRAZIL) SEGURADORA S/A YASUDA SEGUROS S/A ZURICH BRASIL SEGUROS S/A

An

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Annex III: Panel data Regressions Pooling and Random effects

Panel Analysis Pooling and Random Effects (2001-2004) Dependent Variable: DRS Sample: 2001 2004 Included observations: 4 Number of cross-sections used: 61 Total panel (balanced) observations: 244 White Heteroskedasticity-Consistent Standard Errors & Covariance Variable C ALV TAM VIDA HH KEST TAX INV R-squared Adjusted R-squared S.E. of regression F-statistic Prob(F-statistic) Mean dependent var S.D. dependent var Sum squared resid Durbin-Watson stat Pooled least squares Regr. Random Effects Regr. Coefficient t-Statistic Coefficient t-Statistic 809.17 -0.22 -3.79 -5.81 0 -0.15 -0.16 0.14 0.66 0.65 111.57 65.78 0 130.05 188.87 2937442.29 0.36 11.13 -4.78 -3.61 -12.24 -0.15 -0.85 -0.96 0.86 206.74 -0.08446 2.69 -2.61 -0,0033 0.31 0.07 -0.15 0.95 0.95 42.22 130.05 188.87 420740.54 1.17 2.7 -2.91 1.87 -8.49 -2.67 1.04 0.85 -1.43

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Annex IV: Reinsurance and the Production Function of Insurance

The above graph shows the stylized production function of an insurer and describes the role of reinsurance in the production of insurance. On the abscissa, the R variable represents the amount of reinsurance; on the ordinate, the U variable is a composite of the other production factors (capital, land, and labor), supposing there is no coinsurance. Curves X1, X2 e X3 are isoquantic, that is locus of R and U combinations that produce the same amount of insurance. Moving upwards and rightwards, production is increasing, that is X3 > X2 > X1. All the isoquantic variables cross the ordinate, as shown at point E1, but do not cross the abscissa. That means that the more use of reinsurance, the more the other production factors tend towards zero but do not reach zero. Thus, the minimization of a given production cost, whose factor price relative is expressed by line E1 R2, occurs at point E1. In other words, with null reinsurance, there is a E1 finite amount of the other production factors and a given production amount yielded by the isoquantic variable X1. Insurance supply, therefore, may occur independently of the use of reinsurance. Nevertheless, if reinsurance relative price falls, its use increases and the same occurs with production levels, as shown at points E2 e E3. At E2, the factors relative price is established by line E1 E2 and the companys point of equilibrium occurs at E2, given the use of R2 units of reinsurance, U2 units of the other factors, and a X2 (> X1) production level. If reinsurance relative price falls, as established by line E1 E3, the use of reinsurance jumps to R3, the same occurring with production levels, which rise to X3. In sum, ceteris paribus, the lower reinsurance relative price, the more frequent its use and the higher insurance production levels.

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Annex V: Reinsurance and Insurance Market Equilibrium

Typically, every monopoly rations supply so as to be able to charge a higher price for its products. In doing so, higher profits are ensured, since to this rationed amount corresponds a unit cost that is lower than the final price. Some specific actions may hinder this trend, such as the threat of new competitors, who are attracted by the high prices practiced by this market, and state regulation that may establish, through administrative actions, a supply price equal to or close to what would prevail in competitive markets. This forces the monopoly holder to supply a higher quantity of products at lower prices. Obviously, this regulation is expected to be easier in the case of state monopolies as IRB, but that cannot be taken as a rule. In other words, this is more of an empirical than theoretical issue. And, as shown above, the signs are that IRB charged, on average, higher reinsurance prices than those charged by the biggest international insurers. The graph above shows the possible effects of a monopoly upon the supply of a production factor like reinsurance on the insurance market equilibrium. In a competitive market, the initial equilibrium occurs when the insurance supply curves meet (S0, dependent on competitive reinsurance price Pr0) and the respective demand (D). At point e0, the market produces the amount S0 of insurance at an average price of Ps0. A profit-maximizing market limits the supply and charges, on average (as these are multi-product companies), higher prices for the production factors it produces. Therefore, the market actions cause the insurance supply curve to move upward and leftward, at S1, whose argument is the reinsurance price Pr1 higher than Pr0. A new equilibrium points reached at e1, with a higher

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amount of insurance being operated (Q1) and at a higher price (P1) than in the previous situation. The threat of competition and/or regulatory actions could force the monopolizing reinsurer to charge the competitive reinsurance price Pr0 and so, the market equilibrium point would go back to e0. A regulation error might also occur, and that would be forcing the monopoly holder to supply a factor at a lower price than it would if the market were competitive. In this case, the monopoly holder would reduce the supply, which would lead to an excess of demand for this factor. Some insurers manage to acquire the factor at the lower price established by the regulatory body, but in the market as a whole the insurance supply would be rationed, thus leading to a gap between the supply price and the demand price. This is shown in the graph at point e2, where the lower reinsurance price reduces its supply and determines a rationed amount of insurance at Q1. At this point, a gap is established between the insurance supply price (P2), which is reduced as a consequence of the lower reinsurance price, and the demand price (P1) which turns into gross profit for the set of insurance companies (although with a probably uneven distribution among them).

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Annex VI: Simultaneous Estimation of the model supplied by equations (2) and (5) 43
Estimation Method: Seemingly Unrelated Regression Sample: 1971 2004 Included observations: 35 Total system (balanced) observations 68 Convergence achieved after: 1 weight matrix, 12 total coef iterations Coefficient C(1) C(2) C(3) C(4) C(5) C(6) C(7) C(8) C(9) C(10) C(11) C(12) C(13) C(14) 14.76 -1.89 1.54 2.18 0.06 -11.31 1220.79 -0.17 0.64 3.83 0.76 3.69 0.66 0.70 Std. Error 1.89 0.66 0.51 0.60 0.95 2.19 188.48 0.04 0.34 1.40 0.15 0.50 0.14 0.07 0,04 t-Statistic 7.81 -2.84 3.04 3.66 0.06 -5.17 6.48 -3.84 1.87 2.73 5.05 7.41 4.69 9.30 Prob. 0.00 0.01 0.00 0.00 0.95 0.00 0.00 0.00 0.07 0.01 0.00 0.00 0.00 0.00

Determinant residual covariance

Equation: (PREM/PL) = C(1) + C(2)*(DRSSL/PL) + C(3)*COMPET1 + [AR(1)=C(4)] Observations: 34 R-squared 0.92 Mean dependent var 1.81 Adjusted R-squared 0.91 S.D. dependent var 0.61 S.E. of regression 0.18 Sum squared resid 0.96 Durbin-Watson stat 2.09 Equation: DRSSL*100/PREM = C(1) + C(2)*PRSS + C(3)*D(PRSS) + C(4)*((PREM/PL)-(DRSSL/PL)) + C(5)*D(((PREM/PL)-(DRSSL /PL))) + C(6)*(PREM*100000/PIB) + C(7)*(PREM*100000/(PIB *NE)) + C(8)*VIDA + C(9)*PASS + C(10)*COMPET Observations: 34 R-squared 0.90 Mean dependent var 9.81 Adjusted R-squared 0.86 S.D. dependent var 3.94 S.E. of regression 1.46 Sum squared resid 51.19 Durbin-Watson stat 2.01

The coefficients c(1) to c(4) refer to equation (5) in the text and c(5) to c(14) refer to equation (2). As shown, the results are similar to those mentioned in the
It is relatively hard to characterize identification and to investigate its consequences upon nonlinear models in their structural forms, as is the case of the model supplied by equations (2) and (5), and to determine the endogenous variables DRSSL and PREM. Therefore, we moved ahead straight into the estimation of the model. For more on this, see Dufour (2003).
43

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text in what refers to the magnitude of the coefficients, their signs and statistic significance, as well as to the other regression parameters. Through this method, the simulation exercise leads to a projection of the demand for reinsurance, without the reversion of coinsurance, worth R$ 6.6 billion in 2007 (5.2% below the previous projection) and the insurance premiums, worth R$ 61.4 billion, in the same year (0.9% below the previous projection).

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