Economic Impact of Capital Level in an Insurance Company

This paper examines the impact of capital level on policy premium and shareholder return. If an insurance firm has a chance of default, it covers less liability than a default-free firm does, so it charges less premium. We explain why policyholders require greater premium credits than the uncovered liabilities. In a default-free firm, if frictional costs are ignored, we prove shareholders are indifferent to the capital level. This is a restatement of the Modigliani-Miller theorem in the insurance setting. An insurance firm incurs two classes of frictional costs: the frictional costs of capital and the costs of financial distress. Altering the capital level has an opposite effect on each class. The total frictional cost can be minimized at a proper capital level.