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Capital requirements or pricing constraints? An economic analysis of measures for insurance regulation

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  • Schlütter, Sebastian
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    Abstract

    Depending on the point of time and location, insurance companies are subject to different forms of solvency regulation. In modern regulation regimes, such as the future standard Solvency II in the EU, insurance pricing is liberalized and risk-based capital requirements will be introduced. In many economies in Asia and Latin America, on the other hand, supervisors require the prior approval of policy conditions and insurance premiums, but do not conduct risk-based capital regulation. This paper compares the outcome of insurance rate regulation and risk-based capital requirements by deriving stock insurers' best responses. It turns out that binding price floors affect insurers' optimal capital structures and induce them to choose higher safety levels. Risk-based capital requirements are a more efficient instrument of solvency regulation and allow for lower insurance premiums, but may come at the cost of investment efforts into adequate risk monitoring systems. The paper derives threshold values for regulator's investments into risk-based capital regulation and provides starting points for designing a welfare-enhancing insurance regulation scheme. --

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    Bibliographic Info

    Paper provided by International Center for Insurance Regulation (ICIR), Goethe University Frankfurt in its series ICIR Working Paper Series with number 03/11.

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    Date of creation: 2011
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    Handle: RePEc:zbw:icirwp:0311

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    1. Robert Klein & Richard Phillips & Wenyan Shiu, 2002. "The Capital Structure of Firms Subject to Price Regulation: Evidence from the Insurance Industry," Journal of Financial Services Research, Springer, Springer, vol. 21(1), pages 79-100, February.
    2. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, American Finance Association, vol. 33(1), pages 177-86, March.
    3. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, Elsevier, vol. 1(1), pages 3-11, June.
    4. Rafael Repullo, 2002. "Capital requirements, market power, and risk-taking in banking," Proceedings, Federal Reserve Bank of Chicago 809, Federal Reserve Bank of Chicago.
    5. Kenneth A. Froot, 2007. "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers," Journal of Risk & Insurance, The American Risk and Insurance Association, The American Risk and Insurance Association, vol. 74(2), pages 273-299.
    6. Michael Sherris, 2006. "Solvency, Capital Allocation, and Fair Rate of Return in Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, The American Risk and Insurance Association, vol. 73(1), pages 71-96.
    7. D'Arcy, Stephen P & Doherty, Neil A, 1990. "Adverse Selection, Private Information, and Lowballing in Insurance Markets," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 63(2), pages 145-64, April.
    8. Gatzert, Nadine & Schmeiser, Hato, 2008. "Combining fair pricing and capital requirements for non-life insurance companies," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(12), pages 2589-2596, December.
    9. Ray Rees & Hugh Gravelle & Achim Wambach, 1999. "Regulation of Insurance Markets," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 24(1), pages 55-68, June.
    10. Grace, Martin F. & Phillips, Richard D., 2008. "Regulator performance, regulatory environment and outcomes: An examination of insurance regulator career incentives on state insurance markets," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(1), pages 116-133, January.
    11. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, American Economic Association, vol. 90(1), pages 147-165, March.
    12. Richard D. Phillips & J. David Cummins & Franklin Allen, 1996. "Financial Pricing of Insurance in the Multiple Line Insurance Company," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 96-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
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