PRICE, FINANCIAL QUALITY, AND CAPITAL FLOWS IN INSURANCE MARKETS

This paper develops a model of price determination in insurance market s. Insurance is provided by firms that are subject to default risk. De mand for insurance is inversely related to insurer default risk and is imperfectly price elastic because of information asymmetries and priv ate information in insurance markets. The model predicts that the pric e of insurance, measured by the ratio of premiums to discounted losses , is inversely related to insurer default risk and that insurers have optimal capital structures. Price may increase or decrease following a loss shock that depletes the insurer's capital, depending on factors such as the effect of the shock on the price elasticity of demand. Emp irical tests using firm-level data support the hypothesis that the pri ce of insurance is inversely related to insurer default risk and provi de evidence that prices declined in response to the loss shocks of the mid-1980s. Journal of Economic Literature Classification Numbers: G22 , G32, G33. (C) 1997 Academic Press.