A simulation of the insurance industry: the problem of risk model homogeneity

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 insuring 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 firm size distributions. We use the model to investigate the problem of risk model homogeneity. Under the European regulatory framework 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, which could be used to test policies and strategies for capital management.

Exploring the Dynamics of the Specialty Insurance Market Using a Novel Discrete Event Simulation Framework: A Lloyd's of London Case Study

“…Moreover, the Bank of England has published working papers utilising the approach (Baptista et al 2016). On the other hand, academics from the Bayes Business School (Owadally et al 2018(Owadally et al , 2019 and The Institute for New Economic Thinking (Farmer & Foley 2009;Farmer & Axtell 2022;Heinrich et al 2021) have all applied ABMs to the insurance market with significant success.…”

“…In the literature, insurance market phenomena such as the underwriting cycle, have been investigated through a variety of approaches ranging from agent-based to time-series models in order to understand the emergence and drivers of these phenomena (Boyer et al 2012;Owadally et al 2019Owadally et al , 2018Heinrich et al 2021;Weiss & Chung 2004;Harrington & Danzon 1994;Venezian 1985). Surprisingly, there seems to be contradictory views with regard to the causes of market cycles, for example, Cummins & Danzon (1997) argues that institutional lags are the main reason behind the liability insurance market cycle in the mid-1980s in North America when analysing insurance company level data.…”

“…Given the interest in modelling the insurance market, researchers have adopted individual-based modelling approaches, to capture new insights and overcome some of the earlier described issues (Owadally et al 2018(Owadally et al , 2019Zhou 2013;England et al 2022;Dubbelboer et al 2017;Heinrich et al 2021). Some researchers have utilised individual-based models to discover stylised facts (Giardina & Bouchaud 2003) such as the emergence of market crashes and bubbles.…”

“…Since the late 90's, IBM applications have grown in popularity, starting from computational social science to ecological studies, biology and environmental sciences. Given its influence in various research fields, the IBM method continues to advance across disciplines, to more relevant areas of research including the modelling of economic markets such as housing, insurance and energy (Owadally et al 2018;Arthur 2006;Hamill & Gilbert 2015;Owadally et al 2019;Farmer & Foley 2009;Heinrich et al 2021;Johnson & Groff 2014;Groff et al 2019;Baptista et al 2016;Ge 2017;Yun & Moon 2020;Heppenstall et al 2007;McLane et al 2011).…”

Research on the Strategy of Sandtable Simulation Management of Xindao ERP Enterprise

“…It is the product of the highly developed business in the world today, with a bright color of the times and practicality. Sand table simulation provides a platform for college students who are willing to participate in business and a racetrack for galloping their will [1,2]. Each participating team, as a management team, takes over a manufacturing enterprise, generally through online simulation of enterprise operation for four accounting years, and finally determines the ranking according to the comprehensive score.…”