Implications of Dynamic Trading for Insurance Markets

Abstract

We study the interaction between insurance and capital markets within a single but general framework. We show that capital markets greatly enhance the risk sharing capacity of insurance markets and the scope of risks that are insurable because efficiency does not depend on the number of agents at risk, nor on risks being independent, nor on the preferences and endowments of agents at risk being the same. We show that agents share risks by buying full coverage for their individual risks and provide insurance capital through stock markets. We show that aggregate risk enters private insurance as a positive loading on insurance prices and despite that agents will buy full coverage. The loading is determined by the risk premium of investors in the stock market and hence does not depend on the agent's willingness to pay. Agents provide insurance capital by trading an equally weighted portfolio of insurance company shares and a riskless asset. We are able to construct agents' optimal trading strategies explicitly and for very general preferences.