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Valuation of insurers’ contingent capital with counterparty risk and price endogeneity

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  • Lo, Chien-Ling
  • Lee, Jin-Ping
  • Yu, Min-Teh

Abstract

This study develops a structural framework to value insurers’ contingent capital with counterparty risk (CR) and overcomes the problem of price endogeneity (PE) in the valuation model. Our results on the focal contingent capital instrument – catastrophe equity put option (CatEPut) – indicate that prices can be significantly overestimated without considering CR and be significantly underestimated without considering PE. This study also examines how CatEPuts affect the buyer’s probability of default (PD). Our results show that buying a CatEPut lowers the PD for high-risk insurers, but not necessarily so for low-risk insurers; however, without taking CR and PE into account, one may significantly overestimate the credit enhancement provided by the CatEPuts.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:jbfina:v:37:y:2013:i:12:p:5025-5035
    DOI: 10.1016/j.jbankfin.2013.09.007
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    3. Wang, Guanying & Wang, Xingchun & Shao, Xinjian, 2022. "Exchange options for catastrophe risk management," The North American Journal of Economics and Finance, Elsevier, vol. 59(C).
    4. Lo, Chien-Ling & Chang, Carolyn W. & Lee, Jin-Ping & Yu, Min-Teh, 2021. "Pricing catastrophe swaps with default risk and stochastic interest rates," Pacific-Basin Finance Journal, Elsevier, vol. 68(C).
    5. Tai, Vivian W. & Lai, Yi-Hsun & Yang, Tung-Hsiao, 2020. "The role of the board and the audit committee in corporate risk management," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
    6. J. C. Arismendi-Zambrano & Vladimir Belitsky & Vinicius Amorim Sobreiro & Herbert Kimura, 2020. "The Implications of Tail Dependency Measures for Counterparty Credit Risk Pricing," Economics Department Working Paper Series n306-20.pdf, Department of Economics, National University of Ireland - Maynooth.
    7. Denis-Alexandre Trottier & Van Son Lai, 2017. "Reinsurance or CAT Bond? How to Optimally Combine Both," Working Papers 2017-003, Department of Research, Ipag Business School.
    8. Chen, Jun-Home & Lian, Yu-Min & Liao, Szu-Lang, 2022. "Pricing catastrophe equity puts with counterparty risks under Markov-modulated, default-intensity processes," The North American Journal of Economics and Finance, Elsevier, vol. 61(C).
    9. Burnecki, Krzysztof & Giuricich, Mario Nicoló & Palmowski, Zbigniew, 2019. "Valuation of contingent convertible catastrophe bonds — The case for equity conversion," Insurance: Mathematics and Economics, Elsevier, vol. 88(C), pages 238-254.
    10. Carolyn W. Chang & Jack S. K. Chang & Min‐Teh Yu & Yang Zhao, 2020. "Portfolio optimization in the catastrophe space," European Financial Management, European Financial Management Association, vol. 26(5), pages 1414-1448, November.
    11. Wang, Xingchun, 2016. "Catastrophe equity put options with target variance," Insurance: Mathematics and Economics, Elsevier, vol. 71(C), pages 79-86.
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    13. Arismendi-Zambrano, Juan & Belitsky, Vladimir & Sobreiro, Vinicius Amorim & Kimura, Herbert, 2022. "The implications of dependence, tail dependence, and bounds’ measures for counterparty credit risk pricing," Journal of Financial Stability, Elsevier, vol. 58(C).
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    More about this item

    Keywords

    Contingent capital; Catastrophe risk; Insurer’s default risk; Catastrophe equity puts; Contingent claim analysis;
    All these keywords.

    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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