Abstract
Negative shocks to industry capital and significant capital adjustment costs have been offered as an explanation of periodic “crises” in the property-liability insurance market. According to these capacity constraint models, in which post-shock production must meet a solvency constraint, increases in price can cause some or perhaps all of the cost of a negative shock to capital to be shifted to policyholders. This article develops a model of insurance supply with capacity constraints and endogenous insolvency risk that incorporates limited liability and potential loss of insurer intangible capital. If industry demand is inelastic with respect to price and capital, the model predicts that price will increase following a negative shock to capital, but by less than the amount needed to fully offset the shock. Equity value and the expected recovery by policyholders for post-shock production are predicted to decline. Elastic demand mitigates shock-induced price increases.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
Angbazo, Lazarus, and Ranga Narayanan. (1993). “A Financial Postmortem of Hurricane Andrew.” Unpublished working paper, Purdue University.
Bernanke, Ben S., and Cara S. Lown (1991). “The Credit Crunch,”Brookings Papers on Economic Activity, 205–248.
Cagle, Julie. (1994). “Natural Disasters, Insurer Stock Prices, and Market Discrimination: The Case of Hurricane Hugo.” Unpublished working paper, Xavier University.
Cummins, J. David, and Patricia M. Danzon. (1991). “Price Shocks and Capital Flows in Property-Liability Insurance.” In J. David Cummins, Scott E. Harrington, and Robert W. Klein (eds.),Cycles and Crises in Property/Casualty Insurance: Causes and Implications for Public Policy. Kansas City: National Association of Insurance Commissioners.
Cummins, J. David, Scott E. Harrington, and Robert W. Klein. (1991). “Cycles and Crises in Property/Casualty Insurance,”Journal of Insurance Regulation 10, 50–93.
Berger, Larry A., J. David Cummins, and Sharon Tennyson. (1992). “Reinsurance and the Liability Insurance Crisis,”Journal of Risk and Uncertainty 5, 253–272.
Doherty, Neil A., and James R. Garven. (1991). “Capacity and the Cyclically of Insurance Markets.” In J. David Cummins, Scott E. Harrington, and Robert W. Klein (eds.),Cycles and Crises in Property/Casualty Insurance: Causes and Implications for Public Policy. Kansas City: National Association of Insurance Commissioners.
Doherty, Neil A., and James R. Garven. (1994). “Insurance Cycles: Interest Rates and the Capacity Constraint Model,”Journal of Business, in press.
Finsinger, Jorg, and Mark Pauly. (1984). “Reserve Levels and Reserve Requirements for Profit Maximizing Insurance Firms.” In G. Bamberg and K. Spremann (eds.),Lecture Notes in Economics and Mathematical Systems. Berlin: Springer-Verlag. Reprinted in Georges Dionne and Scott E. Harrington (eds.),Foundations of Insurance Economics. Boston: Kluwer Academic Publishers, 1991.
Gron, Anne. (1989). “Price and Profit Cycles in the Property-Casualty Insurance Industry.” Mimeo, Massachusetts Institute of Technology.
Gron, Anne. (1994a). “Capacity Constraints and Cycles in Property-Casualty Insurance Markets,”Rand Journal of Economics 25, 110–127.
Gron, Anne. (1994b). “Evidence of Capacity Constraints in Insurance Markets,”Journal of Law and Economics 37, 349–377.
Harrington, Scott E. (1988). “Prices and Profits in the Liability Insurance Market.” In Robert Litan and Clifford Winston (eds.),Liability: Perspectives and Policy. Washington, DC: Brookings Institution.
Harrington, Scott E., and Patricia M. Danzon. (1994). “Price Cutting in Liability Insurance Markets,”Journal of Business 67, 511–538.
Herring, Richard, and Prashant VanKudre. (1987). “Growth Opportunities and Risk-Taking by Financial Intermediaries,”Journal of Finance 42, 586–600.
Lamb, Reinhold P. (1995). “An Exposure Based Analysis of Property-Liability Insurer Stock Values Around Hurricane Andrew,”Journal of Risk and Insurance 62, 111–123.
Lang, Larry H. P., and Rene M. Stulz. (1992). “Contagion and Competitive Intra-Industry Effects of Bankruptcy Announcements: An Empirical Analysis,”Journal of Financial Economics 32, 45–60.
Munch, Patricia, and Dennis Smallwood. (1982). “Theory of Solvency Regulation in the Property and Casualty Insurance Industry.” In Gary Fromm (ed.),Studies in Public Regulation. Cambridge, MA: MIT Press.
Myers, Stewart C. (1977). “Determinants of Corporate Borrowing,”Journal of Financial Economics 5, 147–175.
Myers, Stewart C., and Richard A. Cohn. (1986). “A Discounted Cash Flow Approach to Property-Liability Insurance: Theory and Empirical Results.” In J. David Cummins and Scott E. Harrington (eds.),Fair Rate of Return in Property-Liability Insurance. Boston: Kluwer Publishing.
Myers, Stewart C., and Nicholas Majluf. (1984). “Corporate Financing and Investment Decisions when Firms Have Information that Investors Do Not,”Journal of Financial Economics 13, 187–221.
Shelor, Roger M., Dwight C. Anderson, and Mark L. Cross. (1992). “Gaining from Losses: Property-Liability Insurer Stock Values in the Aftermath of the 1989 California Earthquake,”Journal of Risk and Insurance 59, 476–487.
Winter, Ralph A. (1988). “The Liability Crisis and the Dynamics of Competitive Insurance Markets,”Yale Journal on Regulation 5, 455–499.
Winter, Ralph A. (1991). “The Liability Insurance Market,”Journal of Economic Perspectives 5, 115–136.
Winter, Ralph A. (1992). “The Dynamics of Competitive Insurance Markets,”Journal of Financial Intermediation, in press.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Cagle, J.A.B., Harrington, S.E. Insurance supply with capacity constraints and endogenous insolvency risk. J Risk Uncertainty 11, 219–232 (1995). https://doi.org/10.1007/BF01207787
Issue Date:
DOI: https://doi.org/10.1007/BF01207787