Capacity Constraints and Cycles in Property-Casualty Insurance Markets
AbstractUnderwriting cycles are unexpected in a structurally competitive industry where financial capital is the major determinant of output capacity. "Arbitrage" theories explain underwriting cycles as largely an artifact of institutional lags and reporting practices; "capacity-constraint" theories view insurance markets as characterized by real frictions that cause underwriting cycles by temporarily reducing the industry's capacity to insure risks. Arbitrage theories imply no systematic relationship between capacity and underwriting margins, while capacity-constraint hypotheses predict a negative relationship. This article provides a test of the two theories by examining the empirical relationship between capacity and underwriting margins. The results, using data on four insurance lines, generally support the capacity-constraint hypothesis; unanticipated decreases in capacity cause higher profitability and prices.
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