Department of Finance
Date of this Version
2007
Abstract
Stock insurers can reduce or eliminate agency conflicts between policyholders and stockholders by issuing participating insurance. Despite this benefit, most stock companies don’t offer participating contracts. This study explains why. We study an equilibrium with both stock and mutual insurers in which stockholders set premiums to provide a fair expected return on their investment, and with a policyholder who chooses the insurance contract that maximizes her expected utility. We demonstrate that stockholders cannot profitably offer fully participating contracts, but can profitably offer partially participating insurance. However, when the policyholder participation fraction is high, the fair-return premium is so large that the policyholder always prefers fully participating insurance from the mutual company. Policies with lower levels of policyholder participation are optimal for policyholders with relatively high risk aversion, though such policies are usually prohibited by insurance legislation. Thus, the reason stock insurers rarely issue participating contracts isn’t because the potential benefits are small or unimportant. Rather, profitability or regulatory constraints simply prevent stock insurers from exercising those benefits in equilibrium.
Comments
Published in Journal of Risk and Insurance 74:1 (2007), pp. 185-206; doi 10.1111/j.1539-6975.2007.00207.x Copyright © 2007 The Journal of Risk and Insurance; published by Wiley-Blackwell. Used by permission. http://www.wiley.com/bw/journal.asp?ref=0022-4367