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The role of frictional costs for insurance pricing and insurer default risk

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  • Schlütter, Sebastian
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    Abstract

    This paper analyzes how capital-related frictional costs (e.g., corporate or personal taxes) influence insurers' optimal pricing and safety level decisions. Frictional costs are modeled with an innovative generic approach that is compatible with many realistic forms of taxation. I show that in perfect competition, the insurer will always add the actual value of frictional costs to the premium; however, in imperfect competition, the insurer may overcharge or undercharge for frictional costs to achieve the shareholder-valuemaximizing combination of equity and premium income. Policymakers can enhance welfare by implementing appropriate tax and subsidy schemes that make insurance more affordable and also lower insurers' restraints to hold sufficient equity levels. --

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    Bibliographic Info

    Paper provided by International Center for Insurance Regulation (ICIR), Goethe University Frankfurt in its series ICIR Working Paper Series with number 07/11.

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    Date of creation: 2011
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    Handle: RePEc:zbw:icirwp:0711

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    1. Lisa Grazzini, 2006. "A Note on Ad Valorem and Per Unit Taxation in an Oligopoly Model," Journal of Economics, Springer, vol. 89(1), pages 59-74, October.
    2. Kenneth A. Froot, 2001. "The Market for Catastrophe Risk: A Clinical Examination," NBER Working Papers 8110, National Bureau of Economic Research, Inc.
    3. Gatzert, Nadine & Schmeiser, Hato, 2008. "Combining fair pricing and capital requirements for non-life insurance companies," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2589-2596, December.
    4. James R. GARVEN & Henri Louberge, 1994. "Reinsurance, Taxes And Efficiency: A Contingent Claims Model Of Insurance Market Equilibrium," Finance 9404001, EconWPA.
    5. Hsuan-Chi Chen & Jay R. Ritter, 2000. "The Seven Percent Solution," Journal of Finance, American Finance Association, vol. 55(3), pages 1105-1131, 06.
    6. Helmut Gründl & Hato Schmeiser, 2007. "Capital Allocation for Insurance Companies-What Good IS IT?," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 301-317.
    7. Harrington, Scott E. & Niehaus, Greg, 2003. "Capital, corporate income taxes, and catastrophe insurance," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 365-389, October.
    8. Kenneth A. Froot, 2007. "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 273-299.
    9. Skeath, Susan E. & Trandel, Gregory A., 1994. "A Pareto comparison of ad valorem and unit taxes in noncompetitive environments," Journal of Public Economics, Elsevier, vol. 53(1), pages 53-71, January.
    10. Kenneth A. Froot & Paul G.J. O'Connell, . "On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance," Center for Financial Institutions Working Papers 97-24, Wharton School Center for Financial Institutions, University of Pennsylvania.
    11. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
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