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Combining fair pricing and capital requirements for non-life insurance companies

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  • Gatzert, Nadine
  • Schmeiser, Hato
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    Abstract

    The aim of this article is to identify fair equity-premium combinations for non-life insurers that satisfy solvency capital requirements imposed by regulatory authorities. In particular, we compare target capital derived using the value at risk concept as planned for Solvency II in the European Union with the tail value at risk concept as required by the Swiss Solvency Test. The model framework uses Merton's jump-diffusion process for the market value of liabilities and a geometric Brownian motion for the asset process; fair valuation is conducted using option pricing theory. We show that even if regulatory requirements are satisfied under different risk measures and parameterizations, the associated costs of insolvency - measured with the insurer's default put option value - can differ substantially.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 32 (2008)
    Issue (Month): 12 (December)
    Pages: 2589-2596

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    Handle: RePEc:eee:jbfina:v:32:y:2008:i:12:p:2589-2596

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Insurance regulation Fair valuation Solvency capital requirement Jump-diffusion process;

    References

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    1. Gatzert, Nadine & Schmeiser, Hato, 2008. "The influence of corporate taxes on pricing and capital structure in property-liability insurance," Insurance: Mathematics and Economics, Elsevier, vol. 42(1), pages 50-58, February.
    2. David Cummins, J. & Sommer, David W., 1996. "Capital and risk in property-liability insurance markets," Journal of Banking & Finance, Elsevier, vol. 20(6), pages 1069-1092, July.
    3. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    4. Michael Sherris, 2006. "Solvency, Capital Allocation, and Fair Rate of Return in Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(1), pages 71-96.
    5. Thomas Møller, 2004. "Stochastic orders in dynamic reinsurance markets," Finance and Stochastics, Springer, vol. 8(4), pages 479-499, November.
    6. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
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    Citations

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    Cited by:
    1. Lo, Chien-Ling & Lee, Jin-Ping & Yu, Min-Teh, 2013. "Valuation of insurers’ contingent capital with counterparty risk and price endogeneity," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5025-5035.
    2. Nadine Gatzert & Hato Schmeiser, 2011. "On the risk situation of financial conglomerates: does diversification matter?," Financial Markets and Portfolio Management, Springer, vol. 25(1), pages 3-26, March.
    3. Buch, Arne & Dorfleitner, Gregor & Wimmer, Maximilian, 2011. "Risk capital allocation for RORAC optimization," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 3001-3009, November.
    4. Gatzert, Nadine & Kellner, Ralf, 2011. "The influence of non-linear dependencies on the basis risk of industry loss warranties," Insurance: Mathematics and Economics, Elsevier, vol. 49(1), pages 132-144, July.
    5. Schlütter, Sebastian, 2011. "The role of frictional costs for insurance pricing and insurer default risk," ICIR Working Paper Series 07/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.
    6. de Haan, Leo & Kakes, Jan, 2010. "Are non-risk based capital requirements for insurance companies binding?," Journal of Banking & Finance, Elsevier, vol. 34(7), pages 1618-1627, July.
    7. McShane, Michael K. & Cox, Larry A. & Butler, Richard J., 2010. "Regulatory competition and forbearance: Evidence from the life insurance industry," Journal of Banking & Finance, Elsevier, vol. 34(3), pages 522-532, March.
    8. Hato Schmeiser & Caroline Siegel & Joël Wagner, 2012. "The risk of model misspecification and its impact on solvency measurement in the insurance sector," Journal of Risk Finance, Emerald Group Publishing, vol. 13(4), pages 285-308.
    9. Tsai, Ming-Shann & Chen, Lien-Chuan, 2011. "The calculation of capital requirement using Extreme Value Theory," Economic Modelling, Elsevier, vol. 28(1-2), pages 390-395, January.
    10. Schlütter, Sebastian, 2011. "Capital requirements or pricing constraints? An economic analysis of measures for insurance regulation," ICIR Working Paper Series 03/11, International Center for Insurance Regulation (ICIR), Goethe University Frankfurt.

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