This paper investigates the valuation effects of reinsurance purchases in a contingent claims fra... more This paper investigates the valuation effects of reinsurance purchases in a contingent claims framework. The comparative statics of the model suggest that, other things equal, the demand for reinsurance will be greater, 1) the higher the firm's leverage, 2) the lower the correlation between the firm's investment returns and claims costs, 3) for firms which write "longer tail" lines of insurance, and 4) the more the firm concentrates its investments in tax-favored assets. These predictions are tested in an empirical analysis of the reinsurance behavior of U.S. property-liability insurance firms during the period 1980-1987. ‡
By most accounts, the Internet and related advances in information technology significantly affec... more By most accounts, the Internet and related advances in information technology significantly affect financial services in general and insurance markets and institutions in particular. Coupled with other important trends such as globalization and regulatory reform, these changes are forcing far-reaching changes upon the insurance industry and making it more competitive. This article focuses specifically on the implications of the Internet for insurance markets and institutions. The conventional wisdom that the Internet constitutes a sufficient condition for the disintermediation of traditional insurance distribution networks is called into question. To the extent that the Internet reduces transaction costs, it will create opportunities for new intermediaries as well as for existing ones. It will also influence product design, in some cases making it economically attractive to unbundle and repackage various forms of coverage. By removing entry barriers and reducing insurance costs, the Internet will also provide a private market solution to a major insurance regulatory concern-enhancing insurance affordability and availability.
In this article, we developed a dynamic market model to obtain the expected returns of individual... more In this article, we developed a dynamic market model to obtain the expected returns of individual securities. This model takes into account certain known characteristics of financial time series, including time-varying beta, autocorrelated squared returns, and the fat-tailed property of daily return data. An autoregressive process with order 1, AR (1), is initialized for beta, and a GARCH (1,1) process is utilized to model the time-varying conditional variance. Our study suggests that the application of the classical event study methodology, without checking the behavior of security returns for stochastic beta and GARCH effects, may very well cause researchers to draw inappropriate conclusions.
This article examines the relationship between risk, return, skewness, and utility-based preferen... more This article examines the relationship between risk, return, skewness, and utility-based preferences. Examples are constructed showing that, for any commonly used utility function, it is possible to have two continuous unimodal random variables X and Y with positive and equal means, X having a larger variance and lower positive skewness than Y, and yet X has larger expected utility than Y, contrary to persistent folklore concerning U″′ > 0 implying skewness preference for risk averters. In additon, it is shown that ceteris paribus analysis of preferences and moments, as occasionally used in the literature, is impossible since equality of higher-order central moments implies the total equality of the distributions involved.
This paper presents an analytical model of underwriting capacity and insurance market equilibrium... more This paper presents an analytical model of underwriting capacity and insurance market equilibrium under an asymmetric corporate tax schedule characterized by incomplete tax-loss offsets. We show that reinsurance causes tax shields to be reallocated to those insurers that have the greatest capacity for utilizing them. Reinsurance is therefore used as an efficient short-run mechanism to yield the optimal allocation of tax shield benefits. In equilibrium, asymmetric taxes cause insurance prices to be actuarially unfair, and the expected return on capital invested in insurance reflects the probability of paying taxes. Journal of Economic Literature Classification Number: G22.
Corporate limited liability creates incentives for owners to shift risks onto creditors by substi... more Corporate limited liability creates incentives for owners to shift risks onto creditors by substituting high-risk assets for low-risk assets because it rewards owners with the benefits of risky activities while penalizing them with only a portion of the costs. However, since rational creditors understand these incentives, the ensuing agency cost is borne ex ante by owners, unless they can credibly precommit themselves not to shift risk onto creditors. This article considers one specific contractual arrangement that helps resolve the risk shifting problem in stock insurers: the inclusion of participation rights in insurance policies. We assume that the insurer chooses between two mutually exclusive investment portfolios, where the riskier portfolio is a mean preserving spread of the less risky portfolio. The primary purpose of this analysis is to demonstrate that participating insurance policies resolve the risk shifting problem for stock insurers. We also present empirical evidence on policyholder participation that is consistent with our theory. , and an anonymous referee. Of course, the usual disclaimer applies. I An insurance policy that includes participation rights is referred to as a "participating policy." Essentially, participating policies enable policyholders to participate in the profits of the firm via dividend payments. In life insurance, dividends are typically paid out of one or more of the following three sources: favorable mortality experience, excess interest earnings on the assets required to maintain legal reserves, and lower than expected operating expenses. Participating policies are less common in property-liability insurance markets, but they do exist. Furthermore, alternative contractual designs such as retrospectively rated policies are in essence participating policies (see Doherty, 1991).
Over the past two decades, several pricing models that integrate underwriting and investment perf... more Over the past two decades, several pricing models that integrate underwriting and investment performance have been proposed or used to determine property4ability insurance rates. In general, these models have been tested separately and only over a relatively limited time horizon. In this article, the major property-liability insurance pricing models are evaluated over the 60-year period from 1926 through 1985 and the results of the various models are compared in terms of the ability to predict actual underwriting profit margins. Differences between model predictions and realized underwriting profit margin series are examined over the entire period as well as various subperiods in order to demonstrate how individual models perform under different conditions.
This paper integrates elements from the theory of financial economics into the theory of the insu... more This paper integrates elements from the theory of financial economics into the theory of the insurance firm. We compare and contrast the received theory of the insurance firm with one that is logically consistent with financial theory, and demonstrate the role played by solvency considerations in the respective approaches. Our analysis suggests that, even in an unregulated market, insurers would very likely voluntarily limit their premiumcapital ratios in an effort to economize on contracting costs. Furthermore, our analysis also suggests that mutual insurers are likely, under certain conditions, to be less highly levered than insurers organized as stock corporations.
This paper investigates the valuation effects of reinsurance purchases in a contingent claims fra... more This paper investigates the valuation effects of reinsurance purchases in a contingent claims framework. The comparative statics of the model suggest that, other things equal, the demand for reinsurance will be greater, 1) the higher the firm's leverage, 2) the lower the correlation between the firm's investment returns and claims costs, 3) for firms which write "longer tail" lines of insurance, and 4) the more the firm concentrates its investments in tax-favored assets. These predictions are tested in an empirical analysis of the reinsurance behavior of U.S. property-liability insurance firms during the period 1980-1987. ‡
By most accounts, the Internet and related advances in information technology significantly affec... more By most accounts, the Internet and related advances in information technology significantly affect financial services in general and insurance markets and institutions in particular. Coupled with other important trends such as globalization and regulatory reform, these changes are forcing far-reaching changes upon the insurance industry and making it more competitive. This article focuses specifically on the implications of the Internet for insurance markets and institutions. The conventional wisdom that the Internet constitutes a sufficient condition for the disintermediation of traditional insurance distribution networks is called into question. To the extent that the Internet reduces transaction costs, it will create opportunities for new intermediaries as well as for existing ones. It will also influence product design, in some cases making it economically attractive to unbundle and repackage various forms of coverage. By removing entry barriers and reducing insurance costs, the Internet will also provide a private market solution to a major insurance regulatory concern-enhancing insurance affordability and availability.
In this article, we developed a dynamic market model to obtain the expected returns of individual... more In this article, we developed a dynamic market model to obtain the expected returns of individual securities. This model takes into account certain known characteristics of financial time series, including time-varying beta, autocorrelated squared returns, and the fat-tailed property of daily return data. An autoregressive process with order 1, AR (1), is initialized for beta, and a GARCH (1,1) process is utilized to model the time-varying conditional variance. Our study suggests that the application of the classical event study methodology, without checking the behavior of security returns for stochastic beta and GARCH effects, may very well cause researchers to draw inappropriate conclusions.
This article examines the relationship between risk, return, skewness, and utility-based preferen... more This article examines the relationship between risk, return, skewness, and utility-based preferences. Examples are constructed showing that, for any commonly used utility function, it is possible to have two continuous unimodal random variables X and Y with positive and equal means, X having a larger variance and lower positive skewness than Y, and yet X has larger expected utility than Y, contrary to persistent folklore concerning U″′ > 0 implying skewness preference for risk averters. In additon, it is shown that ceteris paribus analysis of preferences and moments, as occasionally used in the literature, is impossible since equality of higher-order central moments implies the total equality of the distributions involved.
This paper presents an analytical model of underwriting capacity and insurance market equilibrium... more This paper presents an analytical model of underwriting capacity and insurance market equilibrium under an asymmetric corporate tax schedule characterized by incomplete tax-loss offsets. We show that reinsurance causes tax shields to be reallocated to those insurers that have the greatest capacity for utilizing them. Reinsurance is therefore used as an efficient short-run mechanism to yield the optimal allocation of tax shield benefits. In equilibrium, asymmetric taxes cause insurance prices to be actuarially unfair, and the expected return on capital invested in insurance reflects the probability of paying taxes. Journal of Economic Literature Classification Number: G22.
Corporate limited liability creates incentives for owners to shift risks onto creditors by substi... more Corporate limited liability creates incentives for owners to shift risks onto creditors by substituting high-risk assets for low-risk assets because it rewards owners with the benefits of risky activities while penalizing them with only a portion of the costs. However, since rational creditors understand these incentives, the ensuing agency cost is borne ex ante by owners, unless they can credibly precommit themselves not to shift risk onto creditors. This article considers one specific contractual arrangement that helps resolve the risk shifting problem in stock insurers: the inclusion of participation rights in insurance policies. We assume that the insurer chooses between two mutually exclusive investment portfolios, where the riskier portfolio is a mean preserving spread of the less risky portfolio. The primary purpose of this analysis is to demonstrate that participating insurance policies resolve the risk shifting problem for stock insurers. We also present empirical evidence on policyholder participation that is consistent with our theory. , and an anonymous referee. Of course, the usual disclaimer applies. I An insurance policy that includes participation rights is referred to as a "participating policy." Essentially, participating policies enable policyholders to participate in the profits of the firm via dividend payments. In life insurance, dividends are typically paid out of one or more of the following three sources: favorable mortality experience, excess interest earnings on the assets required to maintain legal reserves, and lower than expected operating expenses. Participating policies are less common in property-liability insurance markets, but they do exist. Furthermore, alternative contractual designs such as retrospectively rated policies are in essence participating policies (see Doherty, 1991).
Over the past two decades, several pricing models that integrate underwriting and investment perf... more Over the past two decades, several pricing models that integrate underwriting and investment performance have been proposed or used to determine property4ability insurance rates. In general, these models have been tested separately and only over a relatively limited time horizon. In this article, the major property-liability insurance pricing models are evaluated over the 60-year period from 1926 through 1985 and the results of the various models are compared in terms of the ability to predict actual underwriting profit margins. Differences between model predictions and realized underwriting profit margin series are examined over the entire period as well as various subperiods in order to demonstrate how individual models perform under different conditions.
This paper integrates elements from the theory of financial economics into the theory of the insu... more This paper integrates elements from the theory of financial economics into the theory of the insurance firm. We compare and contrast the received theory of the insurance firm with one that is logically consistent with financial theory, and demonstrate the role played by solvency considerations in the respective approaches. Our analysis suggests that, even in an unregulated market, insurers would very likely voluntarily limit their premiumcapital ratios in an effort to economize on contracting costs. Furthermore, our analysis also suggests that mutual insurers are likely, under certain conditions, to be less highly levered than insurers organized as stock corporations.
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