Robust Investment-Driven Insurance Pricing and Liquidity Management

Abstract

This paper develops a dynamic equilibrium model of the insurance market that jointly characterizes insurers' underwriting, investment, recapitalization, and dividend policies under model uncertainty and financial frictions. Competitive insurers maximize shareholder value under a subjective worst-case probability measure, giving rise to liquidity-driven underwriting cycles and flight-to-quality behavior. Model uncertainty acts as an informational friction on insurers' risk-taking behavior and helps regularize a finite-barrier verification system in settings with external financial investment opportunities. We further show that robustness concerns do not eliminate the investment-hedging channel in insurance pricing: when underwriting surplus and financial returns are sufficiently negatively correlated, the hedging value of financial investment can be passed through to policyholders, leading to lower insurance prices and, in high-capacity states, negative equilibrium loadings. Thus, underwriting losses may arise endogenously even when insurers price rationally under model uncertainty, rather than necessarily reflecting mispricing or irrational underwriting behavior.