Interest Rates and Cyclical Underwriting Profits in the Property-Liability Insurance Industry: An Equilibrium Approach
Kang, Han Bin
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https://hdl.handle.net/2142/71514
Description
Title
Interest Rates and Cyclical Underwriting Profits in the Property-Liability Insurance Industry: An Equilibrium Approach
Author(s)
Kang, Han Bin
Issue Date
1984
Department of Study
Finance
Discipline
Finance
Degree Granting Institution
University of Illinois at Urbana-Champaign
Degree Name
Ph.D.
Degree Level
Dissertation
Keyword(s)
Economics, Finance
Abstract
Underwriting profits in the property-liability insurance industry have been cyclical for many decades. The insurance industry refers to this behavior as the underwriting profit cycle. This study explains the cycle within the framework of both the insurance and capital markets, using an equilibrium approach. Thus, it seeks to explain the cycle by determining underwriting profits jointly from both insurance and capital market conditions. Demand and supply functions of insurance are developed to determine the equilibrium underwriting profitability. The demand for insurance is hypothesized to increase (decrease) if the expected rate of return is more (less) than the equilibrium rate of return on underwriting which is determined by the capital asset pricing model. The derived supply from the capital asset pricing model is shown to be a positive function of the riskfree interest rate adjusted by the fund-generating coefficient.
The first difference of the simultaneous equation model in this study is estimated to test the hypotheses by using the two-stage least square and the three-stage least square methods. Factors such as interest rates, the amount of the investable funds generated from the sale of insurance, insurance price, as well as conventional demand factors, are shown to affect the cycle. The estimated equilibrium rates of return on underwriting are found to fluctuate over time, resulting in historical fluctuations of underwriting returns. The estimated results of the first differencing model appear to show a significant relationship between the predicted (or equilibrium) and historical changes of underwriting returns.
Based on both financial and economic theory, this study presents an analytical model which explains how underwriting returns are affected by interest rates. The enhanced understanding of the cycle, through the theoretical model in this study, can be helpful for insurers, insureds, and insurance regulators.
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