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A stochastic forward-looking model to assess the profitability and solvency of European insurers
(2016)
In this paper, we develop an analytical framework for conducting forward-looking assessments of profitability and solvency of the main euro area insurance sectors. We model the balance sheet of an insurance company encompassing both life and non-life business and we calibrate it using country level data to make it representative of the major euro area insurance markets. Then, we project this representative balance sheet forward under stochastic capital markets, stochastic mortality developments and stochastic claims. The model highlights the potential threats to insurers solvency and profitability stemming from a sustained period of low interest rates particularly in those markets which are largely exposed to reinvestment risks due to the relatively high guarantees and generous profit participation schemes. The model also proves how the resilience of insurers to adverse financial developments heavily depends on the diversification of their business mix. Finally, the model identifies potential negative spillovers between life and non-life business thorugh the redistribution of capital within groups.
Households buy life insurance as part of their liquidity management. The option to surrender such a policy can serve as a buffer when a household faces a liquidity need. In this study, we investigate empirically which individual and household specific sociodemographic factors influence the surrender behavior of life insurance policyholders. Based on the Socio-Economic Panel (SOEP), an ongoing wide-ranging representative longitudinal study of around 11,000 private households in Germany, we construct a proxy to identify life insurance surrender in the data. We use this proxy to conduct fixed effect regressions and support the results with survival analyses. We find that life events that possibly impose a liquidity shock to the household, such as birth of a child and divorce increase the likelihood to surrender an existing life insurance policy for an average household in the panel. The acquisition of a dwelling and unemployment are further aspects that can foster life insurance surrender. Our results are robust with respect to different models and hold conditioning on region specific trends; they vary however for different age groups. Our analyses contribute to the existing literature supporting the emergency fund hypothesis. The findings obtained in this study can help life insurers and regulators to detect and understand industry specific challenges of the demographic change.
In this paper I assess the effect of interest rate risk and longevity risk on the solvency position of a life insurer selling policies with minimum guaranteed rate of return, profit participation and annuitization option at maturity. The life insurer is assumed to be based in Germany and therefore subject to German regulation as well as to Solvency II regulation. The model features an existing back book of policies and an existing asset allocation calibrated on observed data, which are then projected forward under stochastic financial markets and stochastic mortality developments. Different scenarios are proposed, with particular focus on a prolonged period of low interest rates and strong reduction in mortality rates. Results suggest that interest rate risk is by far the greatest threat for life insurers, whereas longevity risk can be more easily mitigated and thereby is less detrimental. Introducing a dynamic demand for new policies, i.e. assuming that lower offered guarantees are less attractive to savers, show that a decreasing demand may even be beneficial for the insurer in a protracted period of low interest rates. Introducing stochastic annuitization rates, i.e. allowing for deviations from the expected annuitization rate, the solvency position of the life insurer worsen substantially. Also profitability strongly declines over time, casting doubts on the sustainability of traditional life business going forward with the low interest rate environment. In general, in the proposed framework it is possible to study the evolution over time of an existing book of policies when underlying financial market conditions and mortality developments drastically change. This feature could be of particular interest for regulatory and supervisory authorities within their financial stability mandate, who could better evaluate micro- and macro-prudential policy interventions in light of the persistent low interest rate environment.
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.
Common systemic risk measures focus on the instantaneous occurrence of triggering and systemic events. However, systemic events may also occur with a time-lag to the triggering event. To study this contagion period and the resulting persistence of institutions' systemic risk we develop and employ the Conditional Shortfall Probability (CoSP), which is the likelihood that a systemic market event occurs with a specific time-lag to the triggering event. Based on CoSP we propose two aggregate systemic risk measures, namely the Aggregate Excess CoSP and the CoSP-weighted time-lag, that reflect the systemic risk aggregated over time and average time-lag of an institution's triggering event, respectively. Our empirical results show that 15% of the financial companies in our sample are significantly systemically important with respect to the financial sector, while 27% of the financial companies are significantly systemically important with respect to the American non-financial sector. Still, the aggregate systemic risk of systemically important institutions is larger with respect to the financial market than with respect to non-financial markets. Moreover, the aggregate systemic risk of insurance companies is similar to the systemic risk of banks, while insurers are also exposed to the largest aggregate systemic risk among the financial sector.
We designed and fielded an experimental module in the 2014 HRS which seeks to measure older persons’ willingness to voluntarily defer claiming of Social Security benefits. In addition we evaluate the stated willingness of older individuals to work longer, depending on the Social Security incentives offered to delay claiming their benefits. Our project extends previous work by analyzing the results from our HRS module and comparing findings from other data sources, which included very much smaller samples of older persons. We show that half of the respondents would delay claiming if no work requirement were in place under the status quo, and only slightly fewer, 46 percent, with a work requirement. We also asked respondents how large a lump sum they would need with or without a work requirement. In the former case, the average amount needed to induce delayed claiming was about $60,400, while when part-time work was required, the average was $66,700. This implies a low utility value of leisure foregone of only $6,300, or about 10 percent of older households’ income.
In the wake of the recent financial crisis, significant regulatory actions have been taken aimed at limiting risks emanating from banks’ trading activities. The goal of this paper is to look at the alternative reforms in the US, the UK and the EU, specifically with respect to the role of proprietary trading. Our conclusions can be summarized as follows: First, the focus on a prohibition of proprietary trading, as reflected in the Volcker Rule in the US and in the current proposal of the European Commission (Barnier proposal), is inadequate. It does not necessarily reduce risk-taking and it is likely to crowd out desired trading activities, thereby possibly affecting financial stability negatively. Second, trading separation into legally distinct or ring-fenced entities within the existing banking organizations, as suggested under the Vickers Report for the UK and the Liikanen proposal for the EU, is a more effective solution. Separation limits cross-subsidies between banking and proprietary trading and diminishes contagion risk, while still allowing for synergies and risk management across banking, non-proprietary trading and proprietary trading.
We provide an assessment of the Basel Committee on Banking Supervision (BCBS) proposal to restrict the internal ratings-based approach on bank risk and to introduce risk-weighted asset floors. If well enforced, risk-sensitive capital regulation results in a more efficient credit allocation compared to the standard approach. Thus, the internal ratings-based approach should be maintained. Further, the use of internal ratings-based output floors potentially results in unintended negative side effects. Input floors are likely a valuable tool to achieve risk-weighted assets comparability. Finally, the proposed measures have a potential detrimental impact for European banks as compared to others.
I show that disruptions to personal sources of financing, aside from commercial lending supply shocks, impair the survival and growth of small businesses. Entrepreneurs holding deposit accounts at retail banking institutions that defaulted following the financial crisis reduce personal borrowing and are consequently more likely to exit their firm. Exposure to the corresponding investment losses from delisted publicly traded bank stocks strongly reduces the rate of firm survival, particularly for early-stage ventures. At the intensive margin, owners who remain in business reduce employees after personal wealth losses. My results suggest that personal finance is an important component of firm financing.
We develop a model that endogenizes the manager's choice of firm risk and of inside debt investment strategy. Our model delivers two predictions. First, managers have an incentive to reduce the correlation between inside debt and company stock in bad times. Second, managers that reduce such a correlation take on more risk in bad times. Using a sample of U.S. public firms, we provide evidence consistent with the model's predictions. Our results suggest that the weaker link between inside debt and company stock in bad times does not translate into a mitigation of debt-equity conflicts.
This paper compares the dynamics of the financial integration process as described by different empirical approaches. To this end, a wide range of measures accounting for several dimensions of integration is employed. In addition, we evaluate the performance of each measure by relying on an established international finance result, i.e., increasing financial integration leads to declining international portfolio diversification benefits. Using monthly equity market data for three different country groups (i.e., developed markets, emerging markets, developed plus emerging markets) and a dynamic indicator of international portfolio diversification benefits, we find that (i) all measures give rise to a very similar long-run integration pattern; (ii) the standard correlation explains variations in diversification benefits as well or better than more sophisticated measures. These Findings are robust to a battery of robustness checks.
his paper examines whether investor mood, driven by World Health Organization (WHO) alerts and media news on globally dangerous diseases, is priced in pharmaceutical companies' stocks in the United States. We concentrate on irrational investors who buy and sell pharmaceutical companies' stocks guided by beliefs as opposed to rational expectations. We argue that disease-related news (DRNs) should not trigger rational trading. We find that DRNs have a positive and significant sentiment effect among investors (on Wall Street). The effect is stronger (weaker) for small (large) companies, who are less (more) likely to engage in the development of new vaccines in the wake of DRNs. A potential negative mood (on Main Street) – induced by disease related fear – does not alter the positive sentiment effect. Our findings give rise to profitable trading strategies leading to significantly positive performances. Overall, this unparalleled research shows that large events of devastating nature to the economy can be considered as good news to some groups of interest, such as stock market traders.
In a field study with more than 1.500 customers of an online-broker we test what happens when investors receive repeated feedback on their investment success in a monthly securities account report. The reports show investors’ last year’s returns, costs, their current level of risk and their portfolio diversification. We find that receiving a report results in investors trading less, diversifying more and having higher risk-adjusted returns. Results are robust to controlling for potential play money accounts and changes in report designs. We also find that investors who are less likely to subscribe equally benefit from the report.
We study the impact of higher capital requirements on banks’ balance sheets and its transmission to the real economy. The 2011 EBA capital exercise provides an almost ideal quasi-natural experiment, which allows us to identify the effect of higher capital requirements using a difference-in-differences matching estimator. We find that treated banks increase their capital ratios not by raising their levels of equity, but by reducing their credit supply. We also show that this reduction in credit supply results in lower firm-, investment-, and sales growth for firms which obtain a larger share of their bank credit from the treated banks.
This paper studies the role of the Community Reinvestment Act (CRA) in the recent US housing boom-bust cycle. Using a difference-in-differences matching estimation, I find that the enhancement of CRA enforcement in 1998 caused a 7.7 percentage points increase in annual growth rate of mortgage lending by CRA-regulated banks to CRA-eligible census tracts relative to a group of similar-income CRA-ineligible census tracts within the same state. Financial institutions which are not subject to the CRA, however, do not show any change in their mortgage supply between these two types of census tracts after 1998. I take advantage of this exogenous shift in mortgage supply within an instrumental variable framework to identify the causal effect of mortgage supply on housing prices. I find that every 1 percentage point higher annual growth rate of mortgage supply leads to 0.3 percentage points higher annual growth rate of housing prices. Reduced form regressions show that CRA-eligible neighborhoods experienced higher house price growth during the boom and sharper decline during the bust period. I use placebo tests to confirm that this effect is in fact channeled through the shift in mortgage supply by CRA-regulated banks and not by unobserved demand factors. Furthermore, my results indicate that CRA-induced mortgages went to borrowers with lower FICO scores, carried higher interest rates, and encountered more frequent delinquencies.
In order to better differentiate the drivers of corporations’ actions, in particular shareholder wealth and stakeholder interests, the paper explores the significance of the comply or explain-principle and its underlying enforcement mechanisms more generally. Against this background, compliance rates with specific provisions may shed a light on companies’ reasons for following the code. An analysis of these rates at the example of distinct provisions of the German Corporate Governance Code is therefore entered into. In light of the current corporate governance debate and the legitimacy problems that are raised, among the code provisions that exemplify these questions very well are those regulating incentive pay, severance pay caps, and age limits for supervisory board members. Their analysis will lay a basis for an answer to the question about what motivates companies to comply with the code. The motivation then paves the way to arrive at a further specification of the determinants of the regulatory evolution of the Code and the range of stakeholders and their concerns that enter into it.
Little evidence exists on the financing decisions of newly founded firms or on the financing dynamics of these firms over their life cycle. We aim to help filling this gap by investigating the financing dynamics of 2,456 French manufacturing firms founded between 2004 and 2006 through their legally required and reported financial statements. Because we observe significant heterogeneity in the financing decision in the firms' founding year, we focus on analyzing whether these differences widen, persist, or converge by using different convergence concepts. We identify a persistence-cum-convergence pattern. We find the existence of ß-convergence (implying that e.g. firms with lower initial levels of debt accumulate more debt over time) but not of σ-convergence (i.e. we observe an increase in the cross-sectional dispersion of the financing structure). We also show that the dynamics of financing matter for the growth path of the firms.
The ECB’s Outright Monetary Transactions (OMT) program, launched in summer 2012, indirectly recapitalized periphery country banks through its positive impact on the value of sovereign bonds. However, the regained stability of the European banking sector has not fully transferred into economic growth. We show that zombie lending behavior of banks that still remained undercapitalized after the OMT announcement is an important reason for this development. As a result, there was no positive impact on real economic activity like employment or investment. Instead, firms mainly used the newly acquired funds to build up cash reserves. Finally, we document that creditworthy firms in industries with a high prevalence of zombie firms suffered significantly from the credit misallocation, which slowed down the economic recovery.