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Implications of dynamic trading for insurance markets

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  • José Penalva
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    Abstract

    We study the interaction between insurance and capital markets within single but general framework.We show that capital markets greatly enhance the risk sharing capacity of insurance markets and the scope of risks that are insurable because efficiency does not depend on the number of agents at risk, nor on risks being independent, nor on the preferences and endowments of agents at risk being the same. We show that agents share risks by buying full coverage for their individual risks and provide insurance capital through stock markets.We show that aggregate risk enters private insurance as positive loading on insurance prices and despite that agents will buy full coverage. The loading is determined by the risk premium of investors in the stock market and hence does not depend on the agent’s willingness to pay. Agents provide insurance capital by trading an equally weighted portfolio of insurance company shares and riskless asset. We are able to construct agents’ optimal trading strategies explicitly and for very general preferences.

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    File URL: http://www.econ.upf.edu/docs/papers/downloads/720.pdf
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    Bibliographic Info

    Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 720.

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    Date of creation: Dec 2003
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    Handle: RePEc:upf:upfgen:720

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    Web page: http://www.econ.upf.edu/

    Related research

    Keywords: Full insurance; risk sharing; portfolio choice; welfare; heterogeneity;

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    1. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
    2. Mayers, David & Smith, Clifford W, Jr, 1983. "The Interdependence of Individual Portfolio Decisions and the Demand for Insurance," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 304-11, April.
    3. Doherty, Neil A & Dionne, Georges, 1993. " Insurance with Undiversifiable Risk: Contract Structure and Organizational Form of Insurance Firms," Journal of Risk and Uncertainty, Springer, vol. 6(2), pages 187-203, April.
    4. Kenneth A. Froot, 1999. "The Market for Catastrophe Risk: A Clinical Examination," NBER Working Papers 7286, National Bureau of Economic Research, Inc.
    5. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
    6. Malinvaud, E., 1972. "The allocation of individual risks in large markets," Journal of Economic Theory, Elsevier, vol. 4(2), pages 312-328, April.
    7. Scott Harrington & Greg Niehaus, 2002. "Capital Structure Decisions in the Insurance Industry: Stocks versus Mutuals," Journal of Financial Services Research, Springer, vol. 21(1), pages 145-163, February.
    8. Doherty, N A & Tinic, S M, 1981. "Reinsurance under Conditions of Capital Market Equilibrium: A Note," Journal of Finance, American Finance Association, vol. 36(4), pages 949-53, September.
    9. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
    10. Cass, David & Chichilnisky, Graciela & Wu, Ho-Mou, 1996. "Individual Risk and Mutual Insurance," Econometrica, Econometric Society, vol. 64(2), pages 333-41, March.
    11. Zanjani, George, 2002. "Pricing and capital allocation in catastrophe insurance," Journal of Financial Economics, Elsevier, vol. 65(2), pages 283-305, August.
    12. Doherty, Neil A & Schlesinger, Harris, 1983. "Optimal Insurance in Incomplete Markets," Journal of Political Economy, University of Chicago Press, vol. 91(6), pages 1045-54, December.
    13. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-67, April.
    14. Duffie, J Darrell & Huang, Chi-fu, 1985. "Implementing Arrow-Debreu Equilibria by Continuous Trading of Few Long-lived Securities," Econometrica, Econometric Society, vol. 53(6), pages 1337-56, November.
    15. Malinvaud, E, 1973. "Markets for an Exchange Economy with Individual Risks," Econometrica, Econometric Society, vol. 41(3), pages 383-410, May.
    16. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
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