Stochastic Dominance: A Tool for Evaluating Reinsurance Alternatives

During the course of reinsurance coverage negotiations, the prospective reinsured is often presented with a myriad of coverage options. In this situation, two questions naturally arise: - From the reinsured's perspective, which coverage option will yield the optimal long-run economic outcome? - From the reinsurer's perspective, are the options consistently priced? In other words, do the risk loads ensure that each option places the reinsurer in the same long-run economic position? Stochastic dominance is an intuitive, easily implemented, analytical tool used by financial/analysts to evaluate these types of questions. Furthermore, this tool is uniquely suited to the empirical output generated by DFA and other simulation models. Stochastic dominance is a generalization of utility theory that eliminates the need to explicitly specify a firm's utility function. Rather, general mathematical statements about wealth preference, risk aversion, etc. are used to develop optimal decision rules for selecting between investment alternatives. This paper introduces stochastic dominance in a reinsurance context and explores its application to reinsurance pricing and risk loading.