Robust Investment-Driven Insurance Pricing and Liquidity Management

TL;DR

This paper presents a dynamic model of insurance markets that incorporates investment, liquidity, and model uncertainty, revealing new insights into pricing cycles and risk correlations under financial frictions.

Contribution

It introduces a novel equilibrium framework that accounts for model uncertainty and liquidity management, restoring equilibrium existence and uncovering new risk-price relationships.

Findings

Liquidity-driven underwriting cycles and flight-to-quality behavior.

Inclusion of model uncertainty restores equilibrium existence.

Negative insurance loadings can occur with positive correlation between insurance and financial risks.

Abstract

This paper develops a dynamic equilibrium model of the insurance market that jointly characterizes insurers' underwriting, investment, recapitalization, and dividend policies under model uncertainty and financial frictions. Competitive insurers maximize shareholder value under a subjective worst-case probability measure, giving rise to liquidity-driven underwriting cycles and flight-to-quality behavior. While an equilibrium typically fails to exist in such dynamic liquidity management framework with external financial investment, we show that incorporating model uncertainty restores equilibrium existence under plausible parameter conditions. Moreover, the model uncovers a novel relationship between the correlation of insurance and financial market risks and the equilibrium insurance price: negative loadings may emerge when insurance gains and financial returns are positively correlated, contrary to conventional intuition.