Availability crises in liability insurance markets: An application of implicit contract theory with asymmetric information

Lisa Lipowski Posey, University of Pennsylvania


Liability insurance markets experienced severe contractions in supply during 1984 through 1986. Individuals in the industry claim such "crises" occur because insurers "make up" for unfavorable loss experience in prior periods by increasing prices and reducing supply, a strategy not sustainable in a competitive market. This dissertation develops a model which predicts that the quantity of insurance sold and total premium revenue of an insurer will be negatively related to its total losses in the prior period. This is due to the existence of bankruptcy costs, costs of raising equity, switching costs, and an asymmetry of information between the insurers and policyholders regarding the prior period losses of the firm. Unfavorable loss experience reduces surplus available at the beginning of the next period and increases the probability of bankruptcy and, therefore, the expected costs of writing coverage. The asymmetry of information results from the fact that many liability lines are "long-tailed" lines with a large percentage of claims not reported by the end of the period. Insurers have superior information about these losses when compared with individual policyholders. With policyholders facing switching costs once the second period arrives, insurers have an incentive to overprice policies since policyholders don't know what true costs are. This dissertation derives two periods, ex ante Pareto optimal contracts in which price and quantity pairs are chosen for each value of first period losses. An insurer who attempts to choose a price different from the one agree to ex ante is penalized since the quantity which corresponds to that price will be sufficiently low to reduce profits. This signalling mechanism results in rationing of coverage and premium revenue is negatively related to losses in the prior period, or equivalently, positively related to deviations in policyholder surplus. We test the hypothesis that premium revenue is positively related to deviations in surplus on a firm level basis for both the general liability reinsurance market and the general liability primary market using data from the Best tapes for 1980 through 1989. For both markets, the results support the theory.

Subject Area

Business costs

Recommended Citation

Posey, Lisa Lipowski, "Availability crises in liability insurance markets: An application of implicit contract theory with asymmetric information" (1992). Dissertations available from ProQuest. AAI9227744.