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Causal Relationships Between Premiums and Losses, and Causes of the Underwriting Cycles

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Author Info
Ronald K. Chung
Hung-Gay Fung
Gene C. Lai
Robert C. Witt
Abstract

This research explored two major insurance-market issues. First, it investigated the dynamic interactions between premiums and losses using vector autoregressive (VAR) models. Second, it showed how premiums respond to shocks to losses, surplus, interest rates, the variance in losses, and the variance in interest rates. New empirical results based on a decomposition of variance methodology suggest that changes in losses, surplus, interest rates, and uncertainty do explain substantial percentages of variations in premiums. Our results are substantially consistent with an extrapolation hypothesis and a hypothesis of rational expectations with an institutional lag, a capacity-constraint hypothesis, an interest-rate- fluctuation hypothesis, and a change-in-expectations hypothesis. Interestingly, current premiums were found to explain a substantial percentage of the variation in future losses in a two-variable system. This result is consistent with the predictions offered by rational expectations with institutional lags and some financial pricing models for insurance coverages. New evidence on the response of premiums to shocks in various financial variables is also provided by this study. In summary, the pattern generated by impulse response functions for premiums seem to support Cummins and Outreville's hypothesis of rational expectations with an institutional lag, a result which differs somewhat from the observations of Niehaus and Terry (1993).

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Paper provided by EconWPA in its series Risk and Insurance with number 9407008.

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Date of creation: 14 Jul 1994
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Handle: RePEc:wpa:wuwpri:9407008

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Related research
Keywords: Underwriting cycle; vector autoregressive (VAR) models; impulse response functions; premiums; losses; rational expectations; property- liability insurance; decomposition of variance. File Format: Postscript (ASCII) WITT1.ABS;

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  1. Smith, Michael L, 1989. "Investment Returns and Yields to Holders of Insurance," Journal of Business, University of Chicago Press, vol. 62(1), pages 81-98, January. [Downloadable!] (restricted)
  2. Bollerslev, Tim, 1987. "A Conditionally Heteroskedastic Time Series Model for Speculative Prices and Rates of Return," The Review of Economics and Statistics, MIT Press, vol. 69(3), pages 542-47, August. [Downloadable!] (restricted)
  3. Lee, Bong-Soo, 1992. " Causal Relations among Stock Returns, Interest Rates, Real Activity, and Inflation," Journal of Finance, American Finance Association, vol. 47(4), pages 1591-603, September. [Downloadable!] (restricted)
  4. Hamao, Yasushi & Masulis, Ronald W & Ng, Victor, 1990. "Correlations in Price Changes and Volatility across International Stock Markets," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 3(2), pages 281-307. [Downloadable!] (restricted)
  5. Doherty, Neil A. & Kang, Han Bin, 1988. "Interest rates and insurance price cycles," Journal of Banking & Finance, Elsevier, vol. 12(2), pages 199-214, June. [Downloadable!] (restricted)
  6. Greenwald, Bruce C & Stiglitz, Joseph E, 1990. "Asymmetric Information and the New Theory of the Firm: Financial Constraints and Risk Behavior," American Economic Review, American Economic Association, vol. 80(2), pages 160-65, May. [Downloadable!] (restricted)
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  7. Sims, Christopher A, 1972. "Money, Income, and Causality," American Economic Review, American Economic Association, vol. 62(4), pages 540-52, September. [Downloadable!] (restricted)
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