Asymmetric information and insurance cycles

Abstract

AbstractThis paper extends the theoretical literature on underwriting cycles by assuming insurers have heterogeneous exposure to a catastrophe. Distinct from the existing literature on insurance cycles, we model optimal contracting by competitive insurers. Since losses take time to pay out, and insurers are better informed about their catastrophe exposure than external investors, catastrophes compromise the capital‐raising ability of insurers by increasing asymmetric information. Capital is restricted following a catastrophe because investors do not know the catastrophe exposure of each insurer, not because of explicit costs of raising capital. Thus, insurers decide to hold less capital following a catastrophe, giving rise to the insurance cycle.