Jyh-Horng Lin, Xuelian Li and Fu-Wei Huang
This paper aims to theoretically examine the effects of regulatory policyholder protection on spread behavior and default probability of a life insurance company.
Abstract
Purpose
This paper aims to theoretically examine the effects of regulatory policyholder protection on spread behavior and default probability of a life insurance company.
Design/methodology/approach
The authors construct a contingent claim model for the valuation of the equity of a life insurance company. Then, they extend it to model default risk measures associated with a more appropriate behavioral mode of strategic invested asset rate-setting under regulation.
Findings
The findings established that the optimal insurer interest margin is explicitly modeled by a spread between the loan rate and the required guaranteed rate of the company. The effect of the guaranteed rate on the insurer interest margin is positive when the barrier is low, whereas it is negative when the barrier is high. As the barrier increases, the positive effect of the guaranteed rate on the default risk is increased, the negative effect of the participation on the insurer interest margin is decreased and the positive effect of the participation on the default risk is decreased.
Practical implications
Several results derived that should be of interest to investors, analysts, supervising agencies and policymakers. For example, policyholders protected by increasing the guaranteed rate may create a higher risk for the life insurance company to meet its obligations.
Originality/value
The authors’ approach is a significant departure from the existing literature; they differentiate among path-dependent, barrier options and suggest that the life insurance company’s defaults are more commonly triggered by regulatory responses than debt default.
Jyh-Horng Lin, Fu-Wei Huang and Shi Chen
The purpose of this paper is to develop a theoretical framework to answer the following question: What are the consequences of sunflower behavior as well as spread behavior for…
Abstract
Purpose
The purpose of this paper is to develop a theoretical framework to answer the following question: What are the consequences of sunflower behavior as well as spread behavior for how asset-liability management is administrated in a life insurance company?
Design/methodology/approach
This paper takes into account the following: the chief executive officer (CEO) of a life insurance company confirms the board of directors’ belief – the preference of the like of higher return relative to the dislike of higher risk; the authors call such behavior sunflower management; the life insurance policyholder is entitled to a guaranteed interest rate and a participation percentage of the company’s investment surplus; and the authors examine the optimal insurer interest margin, i.e., the spread between the loan rate and the guaranteed rate.
Findings
Sunflower management translates into lower utility for the CEO and makes the CEO more prudent to risk-taking at an increased insurer interest margin for the provision of life insurance contracts. The effect of the guaranteed rate on the margin is ambiguous and depends on the level of guarantee itself. An increase in the participation level decreases the CEO’s loan risk-taking at an increased margin. It is shown that a trend toward higher return like of the board’s belief produces a corresponding trend toward the CEO’s decreasing risk-taking when the return like is revealed strongly. The results indicate that sunflower management as such is an important determinant in ensuring a safe insurance system.
Originality/value
This is the first paper to construct a contingent claim model to evaluate the expected value of the CEO’s utility function defined in terms of the equity returns and the equity risks of a life insurance company. The model explicitly considers CEO sunflower behavior, CEO spread behavior and the limited liability of shareholders.
Details
Keywords
Jyh-Horng Lin, Shi Chen and Fu-Wei Huang
The purpose of this paper is to develop a capped barrier option framework to consider the politically preferential treatment for bank loans incentivized by government capital…
Abstract
Purpose
The purpose of this paper is to develop a capped barrier option framework to consider the politically preferential treatment for bank loans incentivized by government capital injections and calculate loan-risk sensitive insurance premiums.
Design/methodology/approach
This paper takes a capped barrier option approach to the market valuation of the equity of the bank and the liability of the deposit insurer. The cap demonstrates the dynamics of a politically connected borrowing firm’s asset and highlights the truncated nature of loan payoffs. The barrier addresses that default can occur at any time before the maturity date. The bank participating in a government capital injection program is required to fund the politically connected firm that has preferential access to financing.
Findings
Political connection as such makes the bank more prone to risk taking at a reduced interest margin, produces greater safety for the bank owing to government capital injections, and leads to increasing the fair deposit insurance premium. The positive effect of political connection on the deposit insurance premium, which ignores the cap and the barrier yields significant over-estimation.
Originality/value
The study on the politically connected borrowing firm shows that political connection is likely to affect the distressed bank’s performance, yielding the political-connection cost of a reduced bank interest margin and the political-connection benefit of a reduced bank equity risk, contributing the literature on political connection and bank bailout.