Economic Impact of Capital Level in an Insurance Company

Capital level has significant impact on policy premium and shareholder return. A company with less capital is more likely to default on the claim payments, so it should charge less premiums. However, the expected profit may not decline with the premium, since the expected loss payment falls as well. Shareholders provide capital and receive the insurance profit. When the deadweight costs are ignored, the shareholder return is independent of the capital level – similar to the Modigliani-Miller irrelevance theorm. With the deadweight costs, an optimal capital level exists that generates the highest shareholder return. This result is derived using a risk capital model by Perold. The no-arbitage argument, developed by Modigliani and Miller, is throughout the paper that puts our discussions on a solid economic footing.

Keywords Insurance profit, shareholder return, return on capital, no-arbitage, Modigliani-Miller irrelevance, optimal capital level.