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This paper compares the shareholder-value-maximizing capital structure and pricing policy of insurance groups against that of stand-alone insurers. Groups can utilise intra-group risk diversification by means of capital and risk transfer instruments. We show that using these instruments enables the group to offer insurance with less default risk and at lower premiums than is optimal for standalone insurers. We also take into account that shareholders of groups could find it more difficult to prevent inefficient overinvestment or cross-subsidisation, which we model by higher dead-weight costs of carrying capital. The tradeoff between risk diversification on the one hand and higher dead-weight costs on the other can result in group building being beneficial for shareholders but detrimental for policyholders.
Telemonitoring devices can be used to screen consumers' characteristics and mitigate information asymmetries that lead to adverse selection in insurance markets. However, some consumers value their privacy and dislike sharing private information with insurers. In the second-best efficient Wilson-Miyazaki-Spence framework, we allow for consumers to reveal their risk type for an individual subjective cost and show analytically how this affects insurance market equilibria as well as utilitarian social welfare. Our analysis shows that the choice of information disclosure with respect to revelation of their risk type can substitute deductibles for consumers whose transparency aversion is sufficiently low. This can lead to a Pareto improvement of social welfare and a Pareto efficient market allocation. However, if all consumers are offered cross-subsidizing contracts, the introduction of a transparency contract decreases or even eliminates cross-subsidies. Given the prior existence of a WMS equilibrium, utility is shifted from individuals who do not reveal their private information to those who choose to reveal. Our analysis provides a theoretical foundation for the discussion on consumer protection in the context of digitalization. It shows that new technologies bring new ways to challenge crosssubsidization in insurance markets and stresses the negative externalities that digitalization has on consumers who are not willing to take part in this development.
Insurance guarantee schemes aim to protect policyholders from the costs of insurer insolvencies. However, guarantee schemes can also reduce insurers’ incentives to conduct appropriate risk management. We investigate stock insurers’ risk-shifting behavior for insurance guarantee schemes under the two different financing alternatives: a flat-rate premium assessment versus a risk-based premium assessment. We identify which guarantee scheme maximizes policyholders’ welfare, measured by their expected utility. We find that the risk-based insurance guarantee scheme can only mitigate the insurer’s risk-shifting behavior if a substantial premium loading is present. Furthermore, the risk-based guarantee scheme is superior for improving policyholders’ welfare compared to the flat-rate scheme when the mitigating effect occurs.
Coming (great) events cast their (long) shadow before. As the financial crisis gave birth to the creation of the European System of Financial Supervision (ESFS), the imminent Brexit now serves as an impulse to rather extensively reorganize it. Pursuant to the preferences of the Commission—as revealed in its draft for a regulation amending the regulations founding the European Supervisory Authorities (ESA)—the supervision (and regulation) of the financial sectors should be further centralized and integrated and additional powers should be given to the ESAs. To a large degree these alterations are intended to adjust the competences of the European Securities and Markets Authority (ESMA) to better meet its new objectives under the Capital Markets Union (“CMU”). In view that an equivalent to the CMU or the Banking Union—in the sense of a European Insurance Union—is not yet on the horizon for the insurance sector (or the occupational pensions sector), one could prima vista take the view that insurance supervision and regulation is once again taken captive by the necessity of regulatory reforms stemming from other financial sectors. However, even if that is partially the case, the outcome of the intended reforms might still be advantageous for the insurance sector and an important step in the right direction. Therefore, it needs to be intensively discussed.
At this stage, some of the most prominent envisioned changes to the structure, tasks and powers of the European Insurance and Occupational Pensions Authority (EIOPA) and their necessity, usefulness or counter-productivity still have to be examined.
The modern tontine: an innovative instrument for longevity risk management in an aging society
(2016)
The changing social, financial and regulatory frameworks, such as an increasingly aging society, the current low interest rate environment, as well as the implementation of Solvency II, lead to the search for new product forms for private pension provision. In order to address the various issues, these product forms should reduce or avoid investment guarantees and risks stemming from longevity, still provide reliable insurance benefits and simultaneously take account of the increasing financial resources required for very high ages. In this context, we examine whether a historical concept of insurance, the tontine, entails enough innovative potential to extend and improve the prevailing privately funded pension solutions in a modern way. The tontine basically generates an age-increasing cash flow, which can help to match the increasing financing needs at old ages. However, the tontine generates volatile cash flows, so that - especially in the context of an aging society - the insurance character of the tontine cannot be guaranteed in every situation. We show that partial tontinization of retirement wealth can serve as a reliable supplement to existing pension products.
The Liikanen Group proposes contingent convertible (CoCo) bonds as a potential mechanism to enhance financial stability in the banking industry. Especially life insurance companies could serve as CoCo bond holders as they are already the largest purchasers of bank bonds in Europe. We develop a stylized model with a direct financial connection between banking and insurance and study the effects of various types of bonds such as non-convertible bonds, write-down bonds and CoCos on banks' and insurers' risk situations. In addition, we compare insurers' capital requirements under the proposed Solvency II standard model as well as under an internal model that ex-ante anticipates additional risks due to possible conversion of the CoCo bond into bank shares. In order to check the robustness of our findings, we consider different CoCo designs (write-down factor, trigger value, holding time of bank shares) and compare the resulting capital requirements with those for holding non-convertible bonds. We identify situations in which insurers benefit from buying CoCo bonds due to lower capital requirements and higher coupon rates. Furthermore, our results highlight how the Solvency II standard model can mislead insurers in their CoCo investment decision due to economically irrational incentives.
The Liikanen Group proposes contingent convertible (CoCo) bonds as instruments to enhance financial stability in the banking industry. Especially life insurance companies could serve as CoCo bond holders as they are already the largest purchasers of bank bonds in Europe. The growing number of banks issuing CoCo bonds leads to a rising awareness of these hybrid securities among life insurers as they are increasingly looking for higher?yielding investments into bond?like asset classes during the current low interest rate period. Our contribution provides an insight for life insurance companies to understand the effects of holding CoCo bonds as implied by the Solvency II standards that will become effective by 2016.
Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers' balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to relatively high cumulative probability of default for less capitalized companies.
Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers’ balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to a relatively high cumulative probability of default, especially for less capitalized companies. In addition, the new reform of the German life insurance regulation has a beneficial effect on the cumulative probability of default, as a direct consequence of the reduction of the payouts to policyholders.
Testing frequency and severity risk under various information regimes and implications in insurance
(2023)
We build on Peter et al. (2017) who examined the benefit of testing frequency risk under various information regimes. We first consider testing only severity risk, and whether the principle of indemnity, i.e. the usual contract term that excludes claims payments above the resulting insured loss, affects the insurance contracts offered and purchased. Under information regimes which are less restrictive (in terms of obtaining and using customer information), it is possible for the insurer to offer different contracts for tested and untested individuals. In the absence of the principle of indemnity, individuals will test their severity risk and a separating equilibrium ensues. With the principle of indemnity, given an actuarially fair pooled contract, individuals will not test for severity under less restrictive information regimes; a pooling equilibrium thus ensues. Under more restrictive information regimes, the insurer offers separating contracts. Individuals will test for severity and purchase appropriate contracts. We also consider testing for both frequency and severity risk. The results here are more varied. The highest gain in efficiency from testing results from one of the more restrictive information regimes. Generally under all information regimes, there is a greater gain in efficiency without the principle of indemnity than with the principle of indemnity.