A Simulation of the Insurance Industry: The Problem of Risk Model Homogeneity

37 Pages Posted: 14 Jul 2019

See all articles by Torsten Heinrich

Torsten Heinrich

Oxford Martin Programme on Technological and Economic Change, Oxford Martin School, University of Oxford; University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; University of Bremen

Juan Sabuco

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Date Written: July 12, 2019

Abstract

We develop an agent-based simulation of the catastrophe insurance and reinsurance industry and use it to study the problem of risk model homogeneity. The model simulates the balance sheets of insurance firms, who collect premiums from clients in return for ensuring them against intermittent, heavy-tailed risks. Firms manage their capital and pay dividends to their investors, and use either reinsurance contracts or cat bonds to hedge their tail risk. The model generates plausible time series of profits and losses and recovers stylized facts, such as the insurance cycle and the emergence of asymmetric, long tailed firm size distributions. We use the model to investigate the problem of risk model homogeneity. Under Solvency II, insurance companies are required to use only certified risk models. This has led to a situation in which only a few firms provide risk models, creating a systemic fragility to the errors in these models. We demonstrate that using too few models increases the risk of nonpayment and default while lowering profits for the industry as a whole. The presence of the reinsurance industry ameliorates the problem but does not remove it. Our results suggest that it would be valuable for regulators to incentivize model diversity. The framework we develop here provides a first step toward a simulation model of the insurance industry for testing policies and strategies for better capital management.

Keywords: insurance, systemic risk, reinsurance, agent-based simulation, risk modeling

JEL Classification: G22, G28, C63

Suggested Citation

Heinrich, Torsten and Sabuco, Juan and Farmer, J. Doyne, A Simulation of the Insurance Industry: The Problem of Risk Model Homogeneity (July 12, 2019). Available at SSRN: https://ssrn.com/abstract=3419202 or http://dx.doi.org/10.2139/ssrn.3419202

Torsten Heinrich (Contact Author)

Oxford Martin Programme on Technological and Economic Change, Oxford Martin School, University of Oxford ( email )

University of Oxford
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Oxford, OX1 3BD
United Kingdom

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

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Oxford, OX2 6ED
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University of Bremen ( email )

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Juan Sabuco

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

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Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

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