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

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 equilibrium 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 Dynamic Impact of Macro Shocks on Insurance Premiums

“…One possible explanation is that in the face of such a shock, the aggregate consumer price index could be pushed up, resulting in increased underwriting expenses. This argument is consistent that of Lai et al (2000) who suggest that premiums will tend to be high (low) when insurers' expectations about future underwriting expenses are high (low). Figure 2e shows the implications of an unanticipated market-specific shock.…”

“…As Meier (2006a) notes, a structural VAR (SVAR) process that satisfies theoretical conditions is thus the refinement of the traditional VAR technique, which is commonly used in the insurance literature [Lai et al (2000); Ward and Zurbruegg (2000) and Grace and Hotchkiss (1995)]. The SVAR model applies to a system of nonlinear simultaneous equations.…”

“…2 Related studies Fung et al (1998) and Lai et al (2000) have shown that macroeconomic variables have significant effects on insurance premiums over time. Various studies examine the impact of macroeconomic factors such as gross domestic product, short-term interest rates, and inflation on insurance premiums.…”

“…Fung et al (1998) use an unrestricted VAR model to analyze the relation between premiums and losses. Lai et al (2000) provide a broader explanation of determinants of cycles and crises in the general liability market, relying on the traditional VAR models that correspond to particular policies. However, a relevant question that has not been addressed is to what extent the macroeconomic variables affect premiums that have fully adjusted for the effect of losses.…”

The Dynamics of Insurance Prices

“…It is easy to see from Expression (20) that the sign of the insurance price drift is determined by the sign of the polynomial…”