Abstract
This paper offers a novel explanation of the financial underwriting cycle in the property-liability insurance industry. By doing so it resolves that significant anomaly in asset pricing theory posed by cycles in the efficient pricing of insurance coverage. In contrast to the reliance on a variety of institutional or capital market failures underlying all previous explanations of this cycle, we directly augment the complete-markets environment of traditional asset-pricing models through the presence of a single source of risk that cannot be fully hedged through existing financial markets. We realistically interpret this source of risk as unforecastable noise in the implementation of insurance regulations. Cycles in the value of underwriting insurance coverage can arise in this simple variant of a standard complete-markets pricing model owing to the effect of such regulatory risk. We offer a sufficient condition for a stable cycle to endogenously exist in market equilibrium and illustrate this condition in the context of a representative insurance firm and a regulator pursuing a countercyclical policy with noisy implementation. Interestingly, while insurance pricing is efficient in the absence of the regulator, cyclic pricing and underwriting profitability can be induced by a countercyclical regulator policy designed to stabilize the very cycle it creates.
Highlights
The global property-liability insurance industry consistently exhibits recurrent cycles in the pricing, volume and profitability of underwriting coverage
This paper offers a novel explanation of the financial underwriting cycle in the property-liability insurance industry
Our objective is to show that an equilibrium insurance underwriting cycle could occur in our model
Summary
The global property-liability insurance industry consistently exhibits recurrent cycles in the pricing, volume and profitability of underwriting coverage. Set in the context of an economy with incomplete markets, our explanation is based upon the inability of equity investors to fully hedge the risk associated with insurance underwriting Such risk consists of the combination of uncertainty over the evolution of losses in the standard environment of complete private capital markets, which we term exposure risk, and volatility from one or more sources augmenting this standard environment and which cannot be hedged through private markets. Our results can arise in any version of this setting, for simplicity we consider only one such source of volatility We interpret this source as unpredictable randomness in the government implementation and administration of regulations affecting the ability of the insurer to modify premiums and other terms of its coverage. As a consequence, generate cyclic returns to underwriting in an economy that would allow the complete hedging of all risks in the absence of regulatory policy but lacks an adequate number of independent assets to hedge the financial risk arising from the implementation of insurance regulations
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