Abstract

In this paper, we develop a contingent claim model to evaluate the equity, default risk, and efficiency gain/loss from managerial overconfidence of a shadow-banking life insurer under the purchases of distressed assets by the government. Our paper focuses on managerial overconfidence where the chief executive officer (CEO) overestimates the returns on investment. The investment market faced by the life insurer is imperfectly competitive, and investment is core to the provision of profit-sharing life insurance policies. We show that CEO overconfidence raises the default risk in the life insurer’s equity returns, thereby adversely affecting the financial stability. Either shadow-banking involvement or government bailout attenuates the unfavorable effect. There is an efficiency gain from CEO overconfidence to investment. Government bailout helps to reduce the life insurer’s default risk, but simultaneously reduce the efficiency gain from CEO overconfidence. Our results contribute to the managerial overconfidence literature linking insurer shadow-banking involvement and government bailout in particular during a financial crisis.

Highlights

  • The bailout of American International Group (AIG) by the government taking 80%stake on 16 September 2008, was one of the defining moments of the financial crisis (Breitenfellner and Wagner 2010)

  • We extend this strand of the literature by examining the impact of the bailout on bankruptcy prediction when chief executive officer (CEO) overconfidence affecting investment decisions is considered in a life insurance company

  • Overconfidence reveals where α A > 0, and E(OF ) is defined as the ratio when CEO rationality reveals where α A = 0 in our model. ∆E in Equation (8) can be viewed as the equity return differential, per unit of standard deviation, that accrues from insurer investment with CEO overconfidence in lieu of CEO rationality. ∆E > 0 can be interpreted as efficiency gain from CEO overconfidence behavior, whereas ∆E < 0 can be interpreted as efficiency loss

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Summary

Introduction

Stake on 16 September 2008, was one of the defining moments of the financial crisis (Breitenfellner and Wagner 2010). CEO overconfidence associated with relatively low loss reserves results in increasing reported earnings We extend this strand of the literature by examining the impact of the bailout on bankruptcy prediction when CEO overconfidence affecting investment decisions is considered in a life insurance company.. What are the most likely effects of CEO overconfidence on the default risk in the shadow-banking life insurance company’s equity returns in particular when the optimal insurer interest margin is determined? The developed model of insurer spread behavior integrates the risk of a premature default to the equity return valuation along the line of Grosen and Jørgensen (2002) with managerial overconfidence, shadow insurance, and bailout considerations. The elaboration allows us to contribute to the topic of CEO overconfidence and financial crisis when the risk of a premature default to the valuation of a life insurance company is considered.

Literature and Motivation
Model Framework
Assumptions
Equity
Efficiency Gain Prediction
Bankruptcy Prediction
Optimal Decisions and Comparative Static Analyses
Dichotomized Optimal Decisions
Overconfidence Effects
Bailout Effects
Numerical Analysis
Numerical Assumptions
CEO Overconfidence Analysis
Responsiveness
Bailout Analysis
Findings
Conclusions
Full Text
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