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Xuesong You's Abstract

This paper investigates under what circumstances would a loss shock affect the line-specific prices in competitive markets. Specifically, three major questions are discussed: (a) Does a loss shock have to be relevant to the business line to affect insurance prices? (b) Would every loss shock affect the line-specific prices if it is directly relevant to the line of business or the firm? (c) Does and when would a loss shock affect all? A theoretical model in the presence of market competition is developed to analyze how line-specific prices are affected by loss shocks from different sources. The predictions of the model show that the key factor for a loss shock to influence insurance pricing is through the change in the insolvency risk of the insurers. In addition, the competitive element in the market further explains the “contagion” effect of a shock to affect all. My empirical evidence shows that even if one insurer only writes personal lines, an industry-level non-personal-line loss shock would positively affect the personal-line prices, as the outcome of a better competitive position for them being unaffected by the shock. Putting together, one shock does affect all as long as a loss shock threatens the financial quality of firms and changes the competitive dynamics within a market. It could not only affect the prices from the same line but also the prices of other lines under the same firm as well as the prices of other competing insurers in the market.