An examination of the relationships among prices, capital, and portfolio risk in the property-liability insurance industry

This dissertation concerns itself with two important issues in property-liability insurance: the insurance pricing problem and the capital and portfolio risk decisions of insurance firms. The two issues are distinct but interrelated. The factor which links the two issues is insurer default risk. The pricing model developed in the paper yields prices which are dependent upon the default risk of the firm issuing the policies, and demonstrates that the two components which determine default risk are the capital level of the firm and the riskiness of the underlying portfolio of firm assets and liabilities. Chapter One develops an insurance financial pricing model in continuous time which incorporates both default risk and interest rate risk, two factors often ignored in financial pricing models of insurance. After development of the theoretical model and consideration of some special cases, numerical examples are presented. These numerical examples illustrate the impact on insurance prices of insurer capital structure and portfolio risk, as well as the effect of stochastic interest rates. Chapter Two first investigates the implications of the pricing model of Chapter One for the capital and portfolio risk decisions of insurance firms. The impact on these decisions of introducing complete or incomplete guaranty funds into the analysis is then examined. These implications are then combined with other theories to develop the theory of a target level of firm default risk, implying, in turn, target capital ratios and target portfolio risk levels. Finally, the evolution of capital ratios and portfolio risk levels over time are modelled in a partial adjustment framework. Chapter Three investigates empirically what the first two chapters examined theoretically. Time series-cross section data are used to investigate the interrelationships among capital ratios, portfolio risk levels, and prices in the property-liability insurance industry. A positive relationship is found to exist between capital ratios and portfolio risk, while prices are found to indeed be inversely related to firm safety