Value adjustments and dynamic hedging of reinsurance counterparty risk

TL;DR

This paper introduces a new model for reinsurance counterparty risk that captures contagion effects, providing a way to quantify value adjustments and develop dynamic hedging strategies to mitigate RCCR effectively.

Contribution

It proposes a novel contagion-aware model for RCCR, deriving a PIDE for value adjustments and quadratic hedging strategies, with simulation evidence of their effectiveness.

Findings

Dynamic hedging can significantly reduce RCCR.

The model captures contagion effects between reinsurer default and contract prices.

Hedging strategies outperform static approaches in simulations.

Abstract

Reinsurance counterparty credit risk (RCCR) is the risk of a loss arising from the fact that a reinsurance company is unable to fulfill her contractual obligations towards the ceding insurer. RCCR is an important risk category for insurance companies which, so far, has been addressed mostly via qualitative approaches. In this paper we therefore study value adjustments and dynamic hedging for RCCR. We propose a novel model that accounts for contagion effects between the default of the reinsurer and the price of the reinsurance contract. We characterize the value adjustment in a reinsurance contract via a partial integro-differential equation (PIDE) and derive the hedging strategies using a quadratic method. The paper closes with a simulation study which shows that dynamic hedging strategies have the potential to significantly reduce RCCR.