A Growth Theory for the Insurance Industry
Nektarios, Milton, Risk Management and Insurance Review
Insurance economics models of statics and comparative statics assume that the process of economic adjustment must inevitably lead to equilibrium. The question of attainability of equilibrium has not been addressed so far. This is the domain of dynamic analysis. In this article, we develop a model of economic growth for the insurance industry. The production function of the insurance industry is based on the assumption that the output, "incurred losses," is a function of "invested assets" and "other labor and nonlabor inputs." The latter grow at the rate n, a proxy of the growth rate of insurance expenses. The assets-inputs ratio, r, characterizes the steady-state growth path that the insurance industry eventually attains. The adjustment process takes place through the assets-losses ratio, v, which is affected by the insurance leverage, the loss ratio, and the insurance exposure of the insurance industry. An insurance industry that has reached a steady state will have its output growing at the rate n + π, where π is the growth rate of average productivity. The incremental reserve ratio, s, determines definitely a steady-state growth path for the insurance industry. An increase or decrease in s may move the insurance industry to a higher or lower growth path. We suggest that this analysis provides a stronger theoretical context for analyzing dynamic phenomena in the insurance industry.
Insurance economics has grown in importance to become a central theme in modern economics. It all started in the early 1960s with the seminal articles of Borch (1962) and Arrow (1963). Since then, two major research orientations have developed. The first covers the area of microeconomics and may be grouped under three main headings: the demand for insurance and protection, economic equilibrium under asymmetric information, and insurance market structure; this literature has been reviewed by Loubergé (1998). The second research orientation developed in the 1970s and 1980s: insurance has been analyzed more and more in the general framework of financial theory, mainly in the areas of: (1) portfolio theory and the CAPM, (2) option pricing theory, (3) insurance and corporate finance, and (4) insurance and financial markets (Loubergé, 1998).
This article tries to expand insurance economics by applying the theory of economic growth to the insurance industry. We establish a production function for the insurance sector and try to locate those factors that will induce the sector to move to its long-run trend, or potential, growth path.
Economic growth models attempt to explain the observed growth rate of output and its relation to growth rates of inputs. The first three chapters in Romer (1996) present a review of current developments in the theory of economy growth. Growth in the insurance sector may be oi four kinds. First is growth that comes from moving to a position of full resource utilization and optimal economic efficiency. Second is growth from a movement along a full-employment path toward a long-run steady-state path. Third is growth from movement along a steady-state path. And fourth is growth that involves movement between two steady-state paths.
The first type of growth mentioned above represents the usual assumption in microeconomics; that is, insurance firms are fully efficient by operating on the production frontier. However, this framework is not sufficient for a dynamic analysis of the insurance sector. For such an analysis, we must incorporate a number of other variables: the effect of changes in the inputs on the insurance output, the effect of changes in the ratio of inputs, the impact of technological change, etc. Our purpose is to specify such a growth model of the insurances sector.
In the following section, we review the literature and set the ground for the specification of the production function of the insurance industry. In the third section, we develop the growth model for the insurance industry and analyze in detail the adjustment process by means of which the insurance industry will eventually attain its long-run steady-state growth path. …