A Growth Theory for the Insurance Industry

• Published date: 01 March 2010
• DOI: http://doi.org/10.1111/j.1540-6296.2009.01172.x
• Author: Milton Nektarios
• Date: 01 March 2010

C

Risk Management and Insurance Review, 2010, Vol.13, No. 1, 45-60

DOI: 10.1111/j.1540-6296.2009.01172.x

AGROWTH THEORY FOR THE INSURANCE INDUSTRY

Milton Nektarios

ABSTRACT

Insurance economics models of statics and comparative statics assume that the

process of economic adjustment must inevitably lead to equilibrium. The ques-

tion 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 lat-

ter 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 insur-

ance 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 in-

dustry that has reached a steady state will have its output growing at the rate

n+π,whereπis the growth rate of average productivity. The incremental re-

serve ratio, s, determines definitely a steady-state growth path for the insurance

industry. An increas e or decrease i n smay move the insurance industry to a

higher or lower growth path. We suggest that this analysis providesa stronger

theoretical context for analyzing dynamic phenomena in the insurance industry.

INTRODUCTION

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 infor-

mation, and insurance market structure; this literature has been reviewed by Louberg´

e

(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 (Louberg´

e, 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

Milton Nektarios is Associate Professor of Insurance in the Department of Statistics and Insurance

Science, University of Piraeus, Greece; phone: 0030-210-4142271; fax: 0030-210-4142340; e-mail:

nektar@unipi.gr. This article was subject to double-blind peer review.

45

46 RISK MANAGEMENT AND INSURANCE REVIEW

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 of 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 microeco-

nomics; 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 sec-

tor. 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. In the last part of the third section, we add the factor of technical progress

in the growth model. The final section contains the conclusions.

REVIEW OF THE LITERATURE

Insurance economics has not dealt so far with models of dynamic economic growth, al-

though some models of dynamic financial growth have been developed recently (D’Arcy

and Gorvett, 2004).

On the other hand, comparative-statics models have been used in many cases concern-

ing economies of scale in the insurance industry (Doherty, 1981; Fecher et al., 1991;

Cummins and Zi, 1998; Cummins, Tennyson, and Weiss, 1999), business cycles in the

insurance industry (Venezian, 1985; Cummins and Qutreville, 1987; Doherty and Kang,

1988; Lamm-Tennant and Weiss, 1997; Harrington and Niehous, 2000), and measure-

ment of technical progress in the insurance industry (Cummins et al., 1996; Fukuyama,

1997; Cummins and Rubio-Misas, 1998; Cummins, Grace, and Phillips, 1999; Cummins,

Tennyson, and Weiss, 1999).

For our purposes, the most important field of research has been the frontierefficiency and

productivity methodologies that have been developed for measuring the performance

of insurance firms and other financial organizations. This field of research has been

thoroughly reviewed by Cummins and Weiss (2000).

Efficiency theory was developed by Farrell (1957) in order to “compensate” for the

drawback of the traditional microeconomic theory that all firms exhibit optimal behavior.

Farrell defined the efficiency of a firm by reference to the observed and optimal values

of its vector of inputs and outputs.