The role of frictional costs for insurance pricing and insurer default risk

This paper analyzes how capital-related frictional costs (e.g., corporate or personal taxes) influence insurers' optimal pricing and safety level decisions. Frictional costs are modeled with an innovative generic approach that is compatible with many realistic forms of taxation. I show that in perfect competition, the insurer will always add the actual value of frictional costs to the premium; however, in imperfect competition, the insurer may overcharge or undercharge for frictional costs to achieve the shareholder-valuemaximizing combination of equity and premium income. Policymakers can enhance welfare by implementing appropriate tax and subsidy schemes that make insurance more affordable and also lower insurers' restraints to hold sufficient equity levels.