Great (And Not so Great) Expectations: An Endogenous Economic Explication of Insurance Cycles and Liability Crises

Abstract

ABSTRACT The causes of insurance cycles and liability crises have been vigorously sought, claimed, and debated by academic investigators for years. The model provided here partially synthesizes several stands of this literature and provides an additional cause. In addition to causes such as the loss-shocks and interest-rate changes included as explanations in the literature, this model posits changing expectations about the parameters of corporate net income as causes of cycles and crises. Since both sides of the market form expectations about losses and interest rates, changes in both demand and supply in the market are incorporated in the explanation. Changing expectations during the crisis reduced supply and made it more inelastic. The same changing expectations increased demand and made it more inelastic and so amplified the effect due to a change in supply. The model predicts an increase in the equilibrium premium, when the mean and variance of losses increase. The model also predicts an increase in the equilibri um premium when the mean interest rate decreases and variance increases. The empirical results of cross-sectional regression and time-series analyses are consistent with the predictions. The analysis then provides some insight on how to dampen future cycles and reduce the effect of future liability crises. INTRODUCTION Insurance cycles [2] have been recognized for decades and have been the object of study by academic investigators for that long (see Cummins, 1987). The reason for this intense study is both basic (theoretical) and practical. At a basic level, questions arise about whether such cycles conflict with rational corporate decision making in an efficient financial market. From a practical perspective, such cycles can, at their extreme-most valleys, create crises in affordability and availability of insurance, affecting the very productivity of the country involved. The liability insurance crisis in the United States from late 1984 through 1986 is an example of such an extreme in the insurance cycle, being characterized by significant economic disruptions in commercial liability insurance markets. The disruptions created concerns about both the availability and affordability of certain covers. For example, professional and commercial liability insurance consumers were adversely affected by the crisis, as were others such as chemical and pharmaceutical companies, day-care centers, doctors, and municipalities. The cycle ultimately resulting in the crisis was characterized by a sudden increase in liability premiums in late 1984 after about six years of relatively stable prices. An additional response to changes in this cycle included the lowering of policy limits and a reduction in scope of coverage in commercial liability lines that were characterized by long-tails. In addition, insurers were unwilling to provide any coverage at all for some risks, e.g., those involving pollution liability exposures. [3] Academics, attorneys general, consumers, insurers, and regulators have not agreed on the causes of insurance cycles, and the causes of the commercial liability insurance crisis of the late 1980s are still debated. The cycles and crisis theories that do appear in the literature share at least two common characteristics. First, the theories focus on the supply of liability insurance and ignore the demand. Although it is implicit in some theories, the demand for liability insurance during the cycles and crisis is generally not addressed. Second, the theories emphasize a single factor as the cause of the crisis or cycle, although exactly what the single factor is has varied from explanation to explanation. This shared single-factor approach to insurance cycle and crisis explications creates problems. First, the single-factor theories do not explain enough aspects of the crisis, even though each offers some insight. For example, the U. S. Justice Department (Justice, 1986) has cited the expansion of business liability under tort law as the factor explaining higher premiums and reduced coverage limits. …