Reinsurance Demand and Liquidity Creation: A Search for Bi-Causality

Abstract

Our main objective is to establish reciprocal links between reinsurance demand and liquidity creation. Early articles propose that financial institutions enhance economic growth by creating liquidity in the economy. However, liquidity creation exposes firms to liquidity risk because they make themselves illiquid when they create liquidity in the economy. In the insurance industry, unexpected claims can be protected through reinsurance, which introduces a trade-off between the demand for reinsurance and the creation of liquidity. This trade-off can be significant for insurers that have fewer diversification opportunities. Our empirical results, from regularized GMM and ML-SEM estimation methods, show positive bicausal effects between liquidity creation and reinsurance demand for small insurers. The link between the two activities is not significant for large insurers. In all estimations, the standard GMM model is rejected. Our results may have policy implications for liquidity risk management.

Keywords: Reinsurance demand; liquidity creation; liquidity risk management; bicausality; GMM; ML-SEM; policy implication; insurer regulation.

JEL Classification: G20, G21, G22, G32, G38