This article examines the effect of asymmetric information on the trading of underwriting risk between insurers and reinsurers and how it is mitigated in a context of long-term relationships. It begins by explaining how information problems affect the efficiency of the allocation of risk between insurers and reinsurers and how long-term implicit contracts allow the inclusion of new information in the pricing of reinsurance coverage. A key feature of these relationships is the reliance on loss-contingent rebates and commissions in the pricing of reinsurance coverage. We argue that when information is revealed only over time, long-term implicit contracts between insurers and reinsurers allow the inclusion of new information into reinsurance pricing. Because of this feature, the allocation of risk between insurers and reinsurers is more efficient. Specifically, such arrangements lead to more reinsurance coverage, higher insurer profits, and lower expected distress in the industry. Journal of Economic Literature Classification Numbers: G22, G13, L15, D81.

This paper derives the optimal size of the financial sector using a general equilibrium framework that is an extension of the paper of Holmstrom and Tirole (1997) [Quarterly Journal of Economics 112, 663–691]. We show that the financial sector has a unique optimal size relative to the size of the economy as a whole. Creating and maintaining this sector requires diversion of some physical capital from production of output to monitoring that production. However, the efficiency gain in output production brought about by monitoring warrants the diversion. It is also found that the optimal size of the financial sector is independent of the state of the economy and does not vary over the business cycle.