Multiline Insurance with Costly Capital and Limited Liability

We study a competitive multiline insurance industry, in which insurance companies with limited liability choose which insurance lines to cover and the amount of capital to hold. Premiums are determined by no-arbitrage option pricing methods. The results are developed under the realistic assumptions that insurers face friction costs in holding capital and that the losses created by insurer default are shared among policyholders following an ex post, pro rata, sharing rule. In general, the equilibrium ratios of premiums to expected claims and of default costs to expected claims will vary across insurance lines. We characterize the situations in which monoline and multiline insurance offerings will be optimal. Insurance lines characterized by a large number of essentially independent risks will be offered by very large multiline firms. Insurance lines for which the risks are asymmetric or correlated may be offered by monoline insurers. The results are illustrated with examples.