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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.
Central clearing counterparties (CCPs) were established to mitigate default losses resulting from counterparty risk in derivatives markets. In a parsimonious model, we show that clearing benefits are distributed unevenly across market participants. Loss sharing rules determine who wins or loses from clearing. Current rules disproportionately benefit market participants with flat portfolios. Instead, those with directional portfolios are relatively worse off, consistent with their reluctance to voluntarily use central clearing. Alternative loss sharing rules can address cross-sectional disparities in clearing benefits. However, we show that CCPs may favor current rules to maximize fee income, with externalities on clearing participation.
Life insurance convexity
(2023)
Life insurers sell savings contracts with surrender options, which allow policyholders to prematurely receive guaranteed surrender values. These surrender options move toward the money when interest rates rise. Hence, higher interest rates raise surrender rates, as we document empirically by exploiting plausibly exogenous variation in monetary policy. Using a calibrated model, we then estimate that surrender options would force insurers to sell up to 2% of their investments during an enduring interest rate rise of 25 bps per year. We show that these fire sales are fueled by surrender value guarantees and insurers’ long-term investments.
This paper documents that the bond investments of insurance companies transmit shocks from insurance markets to the real economy. Liquidity windfalls from household insurance purchases increase insurers' demand for corporate bonds. Exploiting the fact that insurers persistently invest in a small subset of firms for identification, I show that these increases in bond demand raise bond prices and lower firms' funding costs. In response, firms issue more bonds, especially when their bond underwriters are well connected with investors. Firms use the proceeds to raise investment rather than equity payouts. The results emphasize the significant impact of investor demand on firms' financing and investment activities.
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.
Gradient capital allocation, also known as Euler allocation, is a technique used to redistribute diversified capital requirements among different segments of a portfolio. The method is commonly employed to identify dominant risks, assessing the risk-adjusted profitability of segments, and installing limit systems. However, capital allocation can be misleading in all these applications because it only accounts for the current portfolio composition and ignores how diversification effects may change with a portfolio restructuring. This paper proposes enhancing the gradient capital allocation by adding “orthogonal convexity scenarios” (OCS). OCS identify risk concentrations that potentially drive portfolio risk and become relevant after restructuring. OCS have strong ties with principal component analysis (PCA), but they are a more general concept and compatible with common empirical patterns of risk drivers being fat-tailed and increasingly dependent in market downturns. We illustrate possible applications of OCS in terms of risk communication and risk limits.
Most insurers in the European Union determine their regulatory capital requirements based on the standard formula of Solvency II. However, there is evidence that the standard formula inaccurately reflects insurers’ risk situation and may provide misleading steering incentives. In the second pillar, Solvency II requires insurers to perform a so-called “Own Risk and Solvency Assessment” (ORSA). In their ORSA, insurers must establish their own risk measurement approaches, including those based on scenarios, in order to derive suitable risk assessments and address shortcomings of the standard formula. The idea of this paper is to identify scenarios in such a way that the standard formula in connection with the ORSA provides a reliable basis for risk management decisions. Using an innovative method for scenario identification, our approach allows for a simple but relatively precise assessment of marginal and even non-marginal portfolio changes. We numerically evaluate the proposed approach in the context of market risk employing an internal model from the academic literature and the Solvency Capital Requirement (SCR) calculation under Solvency II.
Between 2016 and 2022, life insurers in several European countries experienced negative longterm interest rates, which put pressure on their business models. The aim of this paper is to empirically investigate the impact of negative interest rates on the stock performance of life insurers. To measure the sensitivities, I estimate the level, slope, and curvature of the yield curve using the Nelson-Siegel model and empirical proxies. Panel regressions show that the effect of changes in the level is up to three times greater in a negative interest rate environment than in a positive one. Thus, a 1ppt decline in long-term interest rates reduces the stock returns of European life insurers by up to 10ppt when interest rates are below 0%. I also show that the relationship between the level and the sensitivity to interest rates is convex, and that life insurers benefit from rising interest rates across all maturity types.
Homeownership rates differ widely across European countries. We document that part of this variation is driven by differences in the fraction of adults co-residing with their parents. Comparing Germany and Italy, we show that in contrast to homeownership rates per household, homeownership rates per individual are very similar during the first part of the life cycle. To understand these patterns, we build an overlapping-generations model where individuals face uninsurable income risk and make consumption-saving and housing tenure decisions. We embed an explicit intergenerational link between children and parents to capture the three-way trade-off between owning, renting, and co-residing. Calibrating the model to Germany we explore the role of income profiles, housing policies, and the taste for independence and show that a combination of these factors goes a long way in explaining the differential life-cycle patterns of living arrangements between the two countries.
In crisis times, insurance companies might feel the pressure to present an investment portfolio performance that is superior to the market, since investment portfolios back the claims of policyholders and serve as a signal for the claims’ safety. I investigate how a stock market crisis as experienced over the course of the Covid-19 pandemic influences insurance firms’ decisions on the allocation of their corporate bond portfolio. I find that insurers shift their portfolio holdings towards lower credit risk assets as financial market conditions tighten. This tendency seems to be restricted by the liquidity risk of high-yield assets, and the credit risk of lower-rated investment grade assets. Both effects lead to an increase in the fraction of less liquid assets during the crash and the recovery.
The capital requirements of Solvency II allow insurers to make discretionary choices. Besides extensive possibilities regarding the choice of a risk model (ranging between a regulatory prescribed standard formula to a full self-developed internal model), insurers can make use of transitional measures and adjustments, which can have a substantial impact on their reported solvency level. The aim of this article is to study the effect of these long-term guarantee measures and to identify drivers of the discretionary decisions. For this purpose, we first assess the risk profile of 49 European insurers by estimating the sensitivities of their stock returns to movements in market risk drivers, such as interest rates and credit spreads. In a second step, we analyze to what extent insurers’ risk profiles influence their discretionary decisions in the capital requirement calculation. We gather information on discretionary decisions based on hand-collected Solvency II data for the years 2016 to 2020. We find that insurers optimize their reported solvency situation by making discretionary decisions in such a way that capital requirements for material risk drivers are clearly reduced. For instance, we find that the usage of the volatility adjustment is positively related to the interest rate risk as perceived by financial markets, even when controlling for the portion of life insurance in technical provisions. Similarly, the matching adjustment is linked to significantly higher credit risk sensitivities. Our results point out that due to discretionary decisions Solvency II figures can substantially deviate from a market-oriented, risk-based view on insurance companies’ risk situation.
We explore how personality traits are related to household borrowing behavior. Using survey data representative for the Netherlands, we consider the Big Five personality traits (openness, conscientiousness, agreeableness, extraversion and neuroticism), as well as the belief that one is master of one’s fate (locus of control). We hypothesize that personality traits can complement as well as substitute financial knowledge of a household. We present three sets of results. First, we find that personality traits are positively correlated with borrowing expectations. Locus of control, extraversion and agreeableness are correlated with informal borrowing expectations, which is the expectation that one can borrow from family and friends. With respect to expectations on the approval of a formal loan application, it is locus of control and conscientiousness that are positively associated. Effect sizes are large and economically meaningful. Second, we find that personality traits are important for borrowing constraints. A more internal locus of control and higher neuroticism are correlated with being denied for credit, as well as discouraged borrowing. Our third set of results reports findings on personality traits and loan regret, and how traits are correlated with dealing with loan troubles. Many households in our sample express regret (21%), but more open, more agreeable and more neurotic individuals are more likely to express regret. Our results are not driven by financial knowledge, time preferences or risk attitudes. Overall these findings imply that non-cognitive traits are important for borrowing behavior of households.
This research focuses on the cost of financing green projects on the primary bond market and tests for a potential price differential between green bonds issued by government entities and those issued by supranational and private sector issuers. Our findings indicate that government entities benefit from more favorable pricing conditions worldwide. This advantage is growing over time and particularly pronounced for sovereigns and municipal authorities. Our analysis also reveals that country-specific factors, such as strong political commitment to address climate change, low income level and high degree of indebtedness are significant predictors of the pricing spread across bonds.
Contagious stablecoins?
(2023)
Can competing stablecoins produce efficient and stable outcomes? We study competition among stablecoins pegged to a stable currency. They are backed by interest-bearing safe assets and can be redeemed with the issuer or traded in a secondary market. If an issuer sticks to an appropriate investment and redemption rule, its stablecoin is invulnerable to runs. Since an issuer must pay interest on its stablecoin if other issuers also pay interest, competing interest-bearing stablecoins, however, are contagious and can render the economy inefficient and unstable. The efficient allocation is uniquely implemented when regulation prevents interest payments on stablecoins.
The Eurosystem and the Deutsche Bundesbank will incur substantial losses in 2023 that are likely to persist for several years. Due to the massive purchases of securities in the last 10 years, especially of government bonds, the banks' excess reserves have risen sharply. The resulting high interest payments to the banks since the turnaround in monetary policy, with little income for the large-scale securities holdings, led to massive criticism. The banks were said to be making "unfair" profits as a result, while the fiscal authorities had to forego the previously customary transfers of central bank profits. Populist demands to limit bank profits by, for example, drastically increasing the minimum reserve ratios in the Eurosystem to reduce excess reserves are creating new severe problems and are neither justified nor helpful. Ultimately, the EU member states have benefited for a very long time from historically low interest rates because of the Eurosystem's extraordinary loose monetary policy and must now bear the flip side consequences of the massive expansion of central bank balance sheets during the necessary period of monetary policy normalisation.
The pricing of digital art
(2023)
The intersection of recent advancements in generative artificial intelligence and blockchain technology has propelled digital art into the spotlight. Digital art pricing recognizes that owners derive utility beyond the artwork’s inherent value. We incorporate the consumption utility associated with digital art and model the stochastic discount factor and risk premiums. Furthermore, we conduct a calibration analysis to analyze the effects of shifts in the real and digital economy. Higher returns are required in a digital market upswing due to increased exposure to systematic risk and digital art prices are especially responsive to fluctuations in business cycles within digital markets.
Can consumption-based mechanisms generate positive and time-varying real term premia as we see in the data? I show that only models with time-varying risk aversion or models with high consumption risk can independently produce these patterns. The latter explanation has not been analysed before with respect to real term premia, and it relies on a small group of investors exposed to high consumption risk. Additionally, it can give rise to a “consumption-based arbitrageur” story of term premia. In relation to preferences, I consider models with both time-separable and recursive utility functions. Specifically for recursive utility, I introduce a novel perturbation solution method in terms of the intertemporal elasticity of substitution. This approach has not been used before in such models, it is easy to implement, and it allows a wide range of values for the parameter of intertemporal elasticity of substitution.
The complexities of geopolitical events, financial and fiscal crises, and the ebb and flow of personal life circumstances can weigh heavily on individuals’ minds as they make critical economic decisions. To investigate the impact of cognitive load on such decisions, the authors conducted an incentivized online experiment involving a representative sample of 2,000 French households. The results revealed that exposure to a taxing and persistent cognitive load significantly reduced consumption, particularly for individuals under the threat of furlough, while simultaneously increasing their account balances, particularly for those not facing such employment uncertainty. These effects were not driven by supply constraints or a worsening of credit constraints. Instead, cognitive load primarily affected the optimality of the chosen policy rules and impaired the ability of the standard economic model to accurately predict consumption patterns, although this effect was less pronounced among college-educated subjects
We investigate how unconventional monetary policy, via central banks’ purchases of corporate bonds, unfolds in credit-saturated markets. While this policy results in a loosening of credit market conditions as intended by policymakers, we report two unintended side effects. First, the policy impacts the allocation of credit among industries. Affected banks reallocate loans from investment-grade firms active on bond markets almost entirely to real estate asset managers. Other industries do not obtain more loans, particularly real estate developers and construction firms. We document an increase in real estate prices due to this policy, which fuels real estate overvaluation. Second, more loan write-offs arise from lending to these firms, and banks are not compensated for this risk by higher interest rates. We document a drop in bank profitability and, at the same time, a higher reliance on real estate collateral. Our findings suggest that central banks’ quantitative easing has substantial adverse effects in credit-saturated economies.
We conduct a field experiment with clients of a German universal bank to explore the impact of peer information on sustainable retail investments. Our results show that infor-mation about peers’ inclination towards sustainable investing raises the amount allocated to stock funds labeled sustainable, when communicated during a buying decision. This effect is primarily driven by participants initially underestimating peers’ propensity to invest sustainably. Further, treated individuals indicate an increased interest in addi-tional information on sustainable investments, primarily on risk and return expectations. However, when analyzing account-level portfolio holding data over time, we detect no spillover effects of peer information on later sustainable investment decisions.