Insurance Cycles: Interest Rates And The Capacity Constraint Model

Although financial pricing models imply that profits of property-liability insurance firms should conform to an unpredictable time series process, cycles are widely reported. Some controversy exists as to whether the "underwriting cycle" is a mere accounting artifact or whether it has real resource effects. We show that changes in interest rates simultaneously affect the insurer's capital structure and the equilibrium level of underwriting profit. Depending on factors such as asset and liability durations, access to capital markets, and availability of capital substitutes such as reinsurance, insurers will be differently affected by changing interest rates. Over time, we find that the average market response to changing interest rates roughly tracks market clearing prices, although the response is somewhat dampened. However, firms with mismatched assets and liabilities, as well as those with more costly access to new capital and reinsurance, are more likely to respond to interest rate changes by either rationing supply or instituting abnormal price changes.