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Different insurance activities exhibit different levels of persistence of shocks and volatility. For example, life insurance is typically more persistent but less volatile than non-life insurance. We examine how diversification among life, non-life insurance, and active reinsurance business affects an insurer's contribution and exposure to the risk of other companies. Our model shows that a counterparty's credit risk exposure to an insurance group substantially depends on the relative proportion of the insurance group's life and non-life business. The empirical analysis confirms this finding with respect to several measures for spillover risk. The optimal proportion of life business that minimizes spillover risk decreases with leverage of the insurance group, and increases with active reinsurance business.
This paper studies insurance demand for individuals with limited financial literacy. We propose uncertainty about insurance payouts, resulting from contract complexity, as a novel channel that affects decision-making of financially illiterate individuals. Then, a trade-off between second-order (risk aversion) and third-order (prudence) risk preferences drives insurance demand. Sufficiently prudent individuals raise insurance demand upon an increase in contract complexity, while the effect is reversed for less prudent individuals. We characterize competitive market equilibria that feature complex contracts since firms face costs to reduce complexity. Based on the equilibrium analysis, we propose a monetary measure for the welfare cost of financial illiteracy and show that it is mainly driven by individuals’ risk aversion. Finally, we discuss implications for regulation and consumer protection.
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.
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 Solvency II standard formula employs an approximate Value-at-Risk approach to define risk-based capital requirements. This paper investigates how the standard formula’s stock risk calibration influences the equity position and investment strategy of a shareholder-value-maximizing insurer with limited liability. The capital requirement for stock risks is determined by multiplying a regulation-defined stock risk parameter by the value of the insurer’s stock portfolio. Intuitively, a higher stock risk parameter should reduce risky investments as well as insolvency risk. However, we find that the default probability does not necessarily decrease when reducing the investment risk (by increasing the stock investment risk parameter). We also find that depending on the precise interaction between assets and liabilities, some insurers will invest conservatively, whereas others will prefer a very risky investment strategy, and a slight change of the stock risk parameter may lead from a conservative to a high risk asset allocation.
European insurers are allowed to make discretionary decisions in the calculation of Solvency II capital requirements. These choices include the design of risk models (ranging from a standard formula to a full internal model) and the use of long-term guarantees measures. This article examines the impact and the drivers of discretionary decisions with respect to capital requirements for market risks. In a first step of our analysis, we assess the risk profiles of 49 stock insurers using daily market data. In a second step, we exploit hand-collected Solvency II data for the years 2016 to 2020. We find that long-term guarantees measures substantially influence the reported solvency ratios. The measures are chosen particularly by less solvent insurers and firms with high interest rate and credit spread sensitivities. Internal models are used more frequently by large insurers and especially for risks for which the firms have already found adequate immunization strategies.
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.
A greater firm-level transparency through enhanced disclosure provides more information regarding the risk situation of an insurer to its outside stakeholders such as stock investors and policyholders. The disclosure of the insurer's risktaking can result in negative influences on, for example, its stock performance and insurance demand when stock investors and policyholders are risk-averse. Insurers, which are concerned about the potential ex post adverse effects of risk-taking under greater transparency, are thus inclined to limit their risks ex ante. In other words, improved firm-level transparency can induce less risktaking incentive of insurers. This article investigates empirically the relationship between firm-level transparency and insurers' strategies on capitalization and risky investments. By exploring the disclosure levels and the risk behavior of 52 European stock insurance companies from 2005 to 2012, the results show that insurers tend to hold more equity capital under the anticipation of greater transparency, and this strategy on capital-holding is consistent for different types of insurance businesses. When considering the influence of improved transparency on the investment policy of insurers, the results are mixed for different types of insurers.
This article explores life insurance consumption in 31 European countries from 2003 to 2012 and aims to investigate the extent to which market transparency can affect life insurance demand. The cross-country evidence for the entire sample period shows that greater market transparency, which resolves asymmetric information, can generate a higher demand for life insurance. However, when considering the financial crisis period (2008-2012) separately, the results suggest a negative impact of enhanced market transparency on life insurance consumption. The mixed findings imply a trade-off between the reduction in adverse selection under greater market transparency and the possible negative effects on life insurance consumption during the crisis period due to more effective market discipline. Furthermore, this article studies the extent to which transparency can influence the reaction of life insurance demand to bad market outcomes: i.e., low solvency ratios or low profitability. The results indicate that the markets with bad outcomes generate higher life insurance demand under greater transparency compared to the markets that also experience bad outcomes but are less transparent.
This paper sheds light on the life insurance sector’s liquidity risk exposure. Life insurers are important long-term investors on financial markets. Due to their long-term investment horizon they cannot quickly adapt to changes in macroeconomic conditions. Rising interest rates in particular can expose life insurers to run-like situations, since a slow interest rate passthrough incentivizes policyholders to terminate insurance policies and invest the proceeds at relatively high market interest rates. We develop and empirically calibrate a granular model of policyholder behavior and life insurance cash flows to quantify insurers’ liquidity risk exposure stemming from policy terminations. Our model predicts that a sharp interest rate rise by 4.5pp within two years would force life insurers to liquidate 12% of their initial assets. While the associated fire sale costs are small under reasonable assumptions, policy terminations plausibly erase 30% of life insurers’ capital due to mark-to-market accounting. Our analysis reveals a mechanism by which monetary policy tightening increases liquidity risk exposure of non-bank financial intermediaries with long-term assets.