The soft budget constraint problem and hard budget solution of outward reinsurance markets for providing insurance to local economy against natural disaster

We show theoretically the commitment effect of a hard budget constraint by letting many reinsurers, including small- and medium-size ones, assume reinsurance (“assume” means undertake reinsurance), instead of a single huge reinsurance company like Munich Re or Swiss Re. Even such huge reinsurance companies do not hold on by themselves. Reinsurers with limited solvency always cede reinsurance to other reinsurance companies. One of the reasons to cede to those with limited solvency is to avoid the soft budget constraint problem of a huge enterprise. It functions as a commitment of the primary insurance company to properly examine the primary contract. That is, for a huge reinsurance company, the possibility of a default occurring subsequently due to false information is low, and so there is an incentive for the primary insurance company not to properly conduct an examination, whereas for small- and medium-size reinsurers, the default risk will be high and it will, therefore, be necessary for the primary insurance company to conduct an appropriate investigation. These analyses shed light on the possibility that small local insurance companies help local society against natural disaster, if they can access international reinsurance market adequately. © 2017, The Japan Section of the Regional Science Association International.