Investment Income and Non-Life Insurance Pricing

The purpose of the paper is to develop a microeconomic theory of a non-life insurance firm in order to derive the profit maximizing price for its intangible product. It is shown that the economic theory of the insurance firm resembles both the theory of the production firm and the theory of the financial intermediary. Moreover, the profit maximizing price for the insurer is found to be one which reflects the marginal revenues and marginal costs associated with both underwriting and financial intermediary activities of the firm. The purpose of this paper is to develop an economic theory of the nonlife insurance firm. A firm which underwrites insurance displays many of the features of the typical production firm since it receives current premium revenues to cover current costs of underwriting. In addition, since the insurer holds a portfolio of earning assets, it displays many of the features of the typical financial intermediary. Given this mixture of operations, the insurer arrives at a profit maximizing price by taking into account the marginal revenues and marginal costs associated with both its underwriting and financial intermediary activities. The first section of this paper specifies the basic assumptions underlying the model of the profit maximizing insurer. Next, the cash balance decision of the insurer as a financial intermediary is discussed. Finally, the profit maximizing price is derived in terms of the marginal costs of underwriting and financial intermediation, given the competitive conditions of the insurance market. In this latter section, the insurer's price derived from a profit maximizing procedure also is compared to a price based upon a mark-up of average costs. The Model