Capital, aggregate risk, insurance prices and regulation

Abstract

We develop a general equilibrium model of competitive insurance and equity capital markets to show how aggregate asset and insurance liability risks affect insurance prices and regulation. In the unique equilibrium of the benchmark unregulated economy, insurers raise external capital solely by selling insurance and no outside equity. We derive the Pareto efficient allocation and implement it via multiple regulatory policies that combine risk-based capital requirements, asset risk constraints, reinsurance and bailouts. An efficient regulatory policy with a lower capital requirement must be accompanied by a more stringent asset risk constraint, and one with a capital requirement that is more sensitive to insurer assets should be less sensitive to insurer liabilities. When the aggregate asset and liability risks are below respective thresholds, insurees are fully insured in the optimally regulated economy, and the set of efficient regulatory policies does not vary with aggregate risk. Outside this region, however, insurees must bear aggregate risk with capital and asset risk constraints becoming tighter as either the aggregate asset or liability risk increases. The aggregate asset and liability risks could have opposing effects on the insurance price and insurer size in the regulated economy. Our results highlight the importance of tailoring regulatory policies to aggregate risk levels, and disentangling the impacts of aggregate asset and liability risks in analyses of how regulation influences insurance prices and insurer capitalization.