Price, Financial Quality, and Capital Flows in Insurance Markets

TLDR

Insurance is provided by firms exposed to default risk, and demand is inversely related to that risk but imperfectly price elastic due to information asymmetries; empirical evidence shows prices fall after loss shocks. This paper develops a model of price determination in insurance markets. The authors construct a theoretical model linking insurer default risk, capital structure, and demand elasticity to determine insurance prices. The model predicts that insurance premiums relative to losses are inversely related to insurer default risk, that insurers adopt optimal capital structures, and that price reactions to loss shocks depend on demand elasticity; empirical data confirm the inverse relationship and show price declines after mid‑1980s loss shocks.

Abstract

This paper develops a model of price determination in insurance markets. Insurance is provided by firms that are subject to default risk. Demand for insurance is inversely related to insurer default risk and is imperfectly price elastic because of information asymmetries and private information in insurance markets. The model predicts that the price of insurance, measured by the ratio of premiums to discounted losses, is inversely related to insurer default risk and that insurers have optimal capital structures. Price may increase or decrease following a loss shock that depletes the insurer's capital, depending on factors such as the effect of the shock on the price elasticity of demand. Empirical tests using firm-level data support the hypothesis that the price of insurance is inversely related to insurer default risk and provide evidence that prices declined in response to the loss shocks of the mid-1980s.Journal of Economic LiteratureClassification Numbers: G22, G32, G33.