Investment Guarantee Research Articles

An Out-of-Sample Analysis of Investment Guarantees for Equity-Linked Products

In this paper we analyze the risk underlying investment guarantees using 78 different econometric models: GARCH, regime-switching, mixtures, and combinations of these approaches. This extensive set of models is compared with returns observed during the financial crisis in an out-of-sample analysis, bringing a new perspective to the study of equity-linked insurance. We find that despite the very good fit of recent models, too few of them are capable of consistently generating low returns over long periods, which were in fact observed empirically during the financial crisis. Moreover, tail risk measures vary significantly across models, and this emphasizes the importance of model risk. Most insurance companies are now focusing on dynamically hedging their investment guarantees, and so we also investigate the robustness of the Black-Scholes delta hedging strategy. We find that hedging errors can be very large among the top fitting models, implying that model risk must be taken into consideration when hedging investment guarantees.

Creating Customer Value in Participating Life Insurance

AbstractThe value of a life insurance contract may differ depending on whether it is looked at from the customer's point of view or that of the insurance company. We assume that the insurer is able to replicate the life insurance contract's cash flows via assets traded on the capital market and can hence apply risk‐neutral valuation techniques. The policyholder, on the other hand, will take risk preferences and diversification opportunities into account when placing a value on that same contract. Customer value is represented by policyholder willingness to pay and depends on the contract parameters, that is, the guaranteed interest rate and the annual and terminal surplus participation rate. The aim of this article is to analyze and compare these two perspectives. In particular, we identify contract parameter combinations that—while keeping the contract value fixed for the insurer—maximize customer value. In addition, we derive explicit expressions for a selection of specific cases. Our results suggest that a customer segmentation in this sense, that is, based on the different ways customers evaluate life insurance contracts and embedded investment guarantees while ensuring fair values, is worthwhile for insurance companies as doing so can result in substantial increases in policyholder willingness to pay.

Investment Guarantees and International Obligations to Reduce Poverty: A Human Rights Perspective

The paper addresses national and international investment guarantee schemes proving political risk insurances as one element of international investment law. The paper proposes to frame the analysis of investment guarantees and poverty reduction in a human rights context. The normative basis for such a framework can be found in the international and potential extraterritorial dimension of economic and social human rights, in particular the right to an adequate standard of living. It is argued that states and international organisations offering investment guarantees are bound by these human rights and have positive obligations to support foreign investment which helps to reduce poverty and to refuse guarantees to projects which would contribute to or increase the risk of poverty. The contribution assesses the practice of different national investment guarantee agencies and of MIGA on a preliminary basis to establish if and how the respective states and international organisations fulfil these obligations.

Price presentation and consumers’ choice

Currently, regulatory authorities and consumers ask for more cost transparency with respect to financial product components. In life insurance, for instance, the premium for products should be split in its components: A premium for death benefits, the savings premium, the cost of an investment guarantee, and the administration costs. In this regard, it is important for insurance companies and regulators to know to what extent the way of presenting the prices of an offer affects consumer evaluation of the product. Based on a paper by Huber et al. (How do price presentation effects influence consumer choice? The case of life insurance products. Working paper, 2011) as presented at the annual meeting of Deutscher Verein fur Versicherungswissenschaft in 2011, this article presents the effects of different forms of presenting the price of life insurance contract components and especially of investment guarantees on consumer evaluation of this product. This is done by means of an experimental study using a representative panel for Switzerland and by focusing on unit-linked life insurance products. The findings reveal that, contrary to consumer products, there is no effect of price bundling and price optic on consumer evaluation and purchase intention for life insurance products. However, there is a significant moderating effect of consumer experience with insurance products on this relationship.

Equity-linked pension schemes with guarantees

This paper analyses the relationship between the level of a return guarantee in an equity-linked pension scheme and the proportion of an investor’s contribution needed to finance this guarantee. Three types of schemes are considered: investment guarantee, contribution guarantee and surplus participation. The evaluation of each scheme involves pricing an Asian option, for which relatively tight upper and lower bounds can be calculated in a numerically efficient manner. We find a negative (and for two contract specifications also concave) relationship between the participation in the surplus return of the investment strategy and the guarantee level in terms of a minimum rate of return. Furthermore, the introduction of the possibility of early termination of the contract (e.g. due to the death of the investor) has no qualitative and very little quantitative impact on this relationship.

Ecuador’s Attainment of the Sumak Kawsay and the Role Assigned to International Arbitration

The current Constitution of Ecuador was approved by referendum on September 28, 2008 and replaces the 1998 Constitution. The text was published on October 20, 2008 in the Official Registry of Ecuador. As Part I of this chapter will explain, the 2008 Ecuadorian Constitution includes Article 422 preventing the Ecuadorian State from ceding its sovereign jurisdiction to international arbitration entities through entering into Treaties or international instruments. This provision is a clear manifestation of the rejection generated in Ecuador by an ex ante and general submission to international tribunals. Additionally, Part I discusses in detail the wording of Article 422, highlighting the doubts and difficulties of interpretation posed by this constitutional provision. Part I finishes by reflecting on two events derived from the approval of Article 422: the denunciation of the ICSID Convention and the denunciation of a number of Bilateral Treaties on the Promotion and Guarantee of Investments (BITs) signed by Ecuador. Part II of this chapter studies some recent judgments of the Ecuadorian Constitutional Court, which have declared many BITs as unconstitutional. A detailed review of these decisions will lead us to make a critical assessment. Part III analyzes the most recent manifestations of the Ecuadorian government regarding international investments. These latest contractual and legislative developments force us to reconsider the real impact that Article 422 of the Constitution is having on Ecuadorian economic life.

Accounting for regime and parameter uncertainty in regime-switching models

As investment guarantees become increasingly complex, realistic simulation of the price becomes more critical. Currently, regime-switching models are commonly used to simulate asset returns. Under a regime switching model, simulating random asset streams involves three steps: (i) estimate the model parameters given the number of regimes using maximum likelihood, (ii) choose the number of regimes using a model selection criteria, and (iii) simulate the streams using the optimal number of regimes and parameter values. This method, however, does not properly incorporate regime or parameter uncertainty into the generated asset streams and therefore into the price of the guarantee. To remedy this, this article adopts a Bayesian approach to properly account for those two sources of uncertainty and improve pricing.

On the Valuation of Investment Guarantees in Unit-linked Life Insurance: A Customer Perspective

Interest rate guarantees in unit-linked life insurance products ensure that at contract maturity, at least a minimum guaranteed amount is paid, even if the mutual fund falls below the guaranteed level. Strongly depending on the riskiness of the underlying mutual fund, these guarantees can be of substantial value. However, while insurer pricing is based on the replication of cash flows, customers are more likely to base their decisions on individual preferences. The aim of this paper is to contrast reservation prices for guarantees in unit-linked life insurance policies based on customers’ subjective willingness to pay with a financial pricing approach, an investigation that has not been undertaken to date. To do so, we use an online questionnaire survey and calculate reservation prices using option pricing theory. Our findings reveal that even though the majority of the participants in the online questionnaire are employed in the field of insurance, subjective prices are difficult to derive and are significantly lower on average than the prices obtained using a financial pricing model. However, a considerable portion of participants is still willing to pay a substantially higher price.

Modeling investment guarantees in Japan: A risk-neutral GARCH approach

The variable annuity market in Japan is still young, but growing rapidly. Most variable annuities in Japan are sold with one or more investment guarantees, such as a Guaranteed Minimum Maturity Benefit (GMMB), which guarantees that the ultimate annuity principal will not fall below a pre-set level regardless of the underlying investment performance. Of interest to financial institutions selling variable annuities is the cost associated with such a guarantee. Although the Black-Scholes option pricing formula can be applied readily, the resulting price might be inaccurate because returns on the Japanese stock price index do not seem to behave as assumed in the formula. In this study, we propose a method for valuing investment guarantees on the basis of a GARCH-type model, which better captures the characteristics of the stock price index. A difficulty in option-pricing with GARCH is the identification of a risk-neutral probability measure. We solve this problem by considering the conditional Esscher transform. Computational details of the proposed method are illustrated by valuing costs of two popular investment guarantees in Japan.

Investment guarantees in unit-linked life insurance from the customer perspective

Interest rate guarantees are a typical contract feature in unit-linked-life insurance products. As the financial crisis of 2007/2008 has shown, these guarantees can be of substantial value for policyholders since they ensure that at least a minimum amount will be paid back even if the mutual fund value falls below a specific guaranteed level. However, from the insurance company’s view, these guarantees can be costly—especially in highly volatile markets—due to the required risk management measures which must be undertaken to secure the guarantees promised to the customers. Thus, the aim of this paper is to investigate whether customers really value these guarantees and if their willingness to pay (WTP) is sufficient to cover the guarantee costs. To elicit customer WTP, we use an online questionnaire and compare these results to the actual guarantee costs calculated with the Black and Scholes option pricing formula. One main finding is that even though most of the participants in the online questionnaire work in the financial industry, subjective prices are difficult to derive and are lower, on average, than the prices obtained using a financial pricing model. However, many participants are still willing to pay a substantially higher price.

Access to Justice, Denial of Justice and International Investment Law

The development of investment arbitration in contemporary international law has helped to consolidate access to justice as a principle of both customary law on the treatment of aliens and human rights law. This development has also contributed to the emancipation of individuals and private entities from the traditional institution of diplomatic protection by opening to them direct access to international dispute settlement mechanisms. At the same time, this development has raised questions whether the far-reaching penetration of foreign investment guarantees into areas of national regulation of public interest should not be counterbalanced by corresponding opportunities for access to justice and the availability of remedies for civil society in the host state. This article examines the relevant recent practice on this matter and argues that access to justice may be a unifying principle to afford protection, both at the substantive and procedural levels, to investors and peoples negatively affected by the investment, both in the territory of the host state and abroad.

Pricing and performance of mutual funds: lookback versus interest rate guarantees

The aim of this paper is to compare pricing and performance of mutual funds with two types of guarantees: a lookback guarantee and an interest rate guarantee. In a simulation analysis of different portfolios based on stock, bond, real estate, and money market indices, we first calibrate guarantee costs to be the same for both investment guarantee funds. Second, their performance is contrasted, measured with the Sharpe ratio, Omega, and Sortino ratio, and a test with respect to first, second, and third order stochastic dominance is provided. We further investigate the impact of the underlying funds strategy, first looking at a conventional fund having a constant average rate of return and standard deviation over the contract term, and then at a Constant Proportion Portfolio Insurance managed fund. This analysis is intended to provide insights for investors with different risk-return preferences regarding the interaction of guarantee costs and the performance of different mutual funds with embedded investment guarantees

The Role of Bilateral Investment Treaties (BITs) in Switzerland: Importance and Alternatives from an Entrepreneurial Perspective

Bilateral investment treaties (BITs) are instruments that aim at promoting and protecting foreign direct investment (FDI). Switzerland holds a leading position worldwide with regard to the negotiation and conclusion of BITs: The Swiss government has ratified 113 of such treaties so far, which means that about every 23rd BIT worldwide is concluded between Switzerland and a third state. Other alternatives for the protection of FDI include (i) political risk insurance (PRI), such as multilateral and national investment guarantees or private investment insurances, (ii) traditional diplomatic protection, and (iii) state contracts, such as concession agreements.The purpose of this paper is to analyze the importance of BITs as well as alternative instruments to safeguard FDI from an entrepreneurial perspective, and to verify whether Swiss enterprises investing abroad appreciate the efforts undertaken by their government. In this endeavor, the first part of the paper outlines the theoretical framework of different instruments offering political risk protection for FDI. The second part of the paper presents the results of an empirical analysis conducted in Switzerland. In this part, a qualitative analysis through explorative and semi-structured interviews, as well as a quantitative analysis using a two-page questionnaire was conducted.The results of the study indicate that BITs are accepted instruments to safeguard FDI in the community of states, and BITs will remain important to private sector companies as long as no multilateral agreement emerges. Particularly small and medium-sized enterprises (SMEs) appreciate these treaties, while state contracts seem to be the most important alternative to BITs, and PRI schemes are fairly unpopular among Swiss enterprises. Although the relationship between BITs and PRI is by far not clear, it is widely acknowledged among practitioners that there is a need for comprehensive strategies, including PRIs in the first place followed by BITs as well as other international institutions.

Equity-Linked Pension Schemes with Guarantees

This paper analyses the relationship between the level of a return guarantee in an equity-linked pension scheme and the proportion of an investor's contribution needed to finance this guarantee. Three types of schemes are considered: investment guarantee, contribution guarantee and participation surplus. The evaluation of each scheme involves pricing an Asian option, for which relatively tight upper and lower bounds can be calculated in a numerically efficient manner.We find a negative (and for two contract specifications also concave) relationship between the participation in the surplus return of the investment strategy and the guarantee level in terms of a minimum rate of return. Furthermore, the introduction of a possibility of early termination of the contract (e.g. due to the death of the investor) has no qualitative and very little quantitative impact on this relationship.

Investment Guarantees and Political Risk Insurance: Institutions, Incentives and Development

Investment Guarantees and Political Risk Insurance: Institutions, Incentives and Development

Multivariate Models of Equity Returns for Investment Guarantees Valuation

In this paper we investigate the valuation of investment guarantees in a multivariate (discrete-time) framework. We present how to build multivariate models in general, and we survey the most important multivariate GARCH models. A direct multivariate application of regime-switching models is also discussed, as is the estimation of these models using maximum likelihood and their comparison in a multivariate setting. The computation of the CTE provision is further presented. We have estimated the models with a multivariate dataset (Canada, United States, United Kingdom, and Japan), and we compared the quality of their fit using multiple criteria and tests. We observe that multivariate GARCH models provide a better overall fit than regime-switching models. However, regime-switching models appropriately represent the fat tails of the returns distribution, which is where most GARCH models fail. This leads to significant differences in the value of the CTE provisions, and, in general, provisions computed with regime-switching models are higher. Thus, the results from this multivariate analysis are in line with what was obtained in the literature of univariate models.

Private Sector Investments from Small States in Emerging Markets: Can International Financial Institutions Help Handle the Risks?

The private sector plays an important role in the economic reconstruction of emerging market economies, and international financial institutions (IFIs) increasingly work in partnership with the private sector to increase economic growth and reduce poverty in those economies. IFIs, for example, offer: (i) equity financing and/or loans for private sector projects, (ii) investment guarantees against political risks (or non-commercial risks), (iii) technical assistance, and (iv) advisory services, etc. This article will briefly discuss the services that IFIs offer the private sector in emerging markets and cases in which these services could be useful for Icelandic companies. The institutions discussed are (i) the World Bank Group, (ii) the European Bank for Reconstruction and Development (EBRD), (iii) the Asian Development Bank (AsDB), (iv) the Inter-American Development Bank (IDB), and (v) the African Development Bank (AfDB). A few Icelandic firms already have plans for relatively large projects in emerging market economies, especially in the energy sector, some of them in countries that could be classified as being risky. The ongoing economic crisis in Iceland will make project financing in emerging markets more problematic than before and therefore investments in partnership with international financial institutions could be an option that Icelandic firms will increasingly need to consider if they intend to invest abroad. However, increased private sector and IFI partnerships will not happen without government action. Iceland is a member of only two of the above-mentioned IFIs: the World Bank Group and the EBRD. The decision for Iceland to become member of the AsDB, IDB and AfDB rests solely with the government. Further government inaction in this area could become an impediment for foreign direct investment from Iceland to emerging markets and increase risks when the Icelandic private sector invests in those economies. Unnecessary risks might not only hurt Icelandic companies but also put Iceland’s economy in jeopardy. This is especially the case with large energy investments with long repayment periods. In addition to the specific case of Iceland, the discussion in this article could also be relevant to other small states which do not have the same leverage as do large states in the event of a dispute with the host governments, making partnership with IFIs more feasible in emerging markets.

Sicherung privater Investitionen – ein geeignetes Instrument der Entwicklungshilfe?

Abstract Peter Egger’s paper provides a synthesis of findings with regard to the impact of bilateral as well as multilateral means of protection of cross-border direct investments in less developed countries and, in turn, on their economic growth. In particular, he focuses on the role of bilateral investment treaties and multilateral agreements such as the GATS in this regard. Previous empirical work identifies a significant positive impact of bilateral investment treaties on FDI. It suggests a similar impact of the GATS on FDI. He argues that these agreements contribute significantly to economic growth in less developed economies and countries in transition by spurring technology transfers through multinational activity of the developed countries in other economies Andreas Freytag and Sebastian Voll emphasize the important role of adequate institutions both for investment and development. The question is, whether investment guarantees as insurance for political risks in the recipient country support economic development or not. Actually, the German Federal Republic is the leading warrantor for FDI-insurances on the world, but the benefiting countries are not the LDC’s. Using these warranties as an instrument of development policy in the future is content of actual political discussion. They argue that, in case of economies with weak domestic institutions, investment guarantees could provide disincentives for politicians in the target country to establish rule of law and good governance. On the other hand, investment guarantees could foster development by providing additional access to FDI, especially in emerging market economies with sufficient and improving institutional quality Philipp Harms points out while foreign direct investment (FDI) flows to developing countries and emerging markets have increased substantially in recent years, many low-income countries are still shunned by multinational firms. One of the key causes for this observation is the poor quality of institutions and an often precarious political environment in these countries. Given the benefits of FDI for host country productivity and income levels, it could thus be argued that protecting the security of property rights is an effective way of enhancing growth and prosperity in poor countries. While he agrees with this point of view, he argues that “traditional” forms of development aid can substantially contribute to an improved investment climate in developing countries. This argument is based on the notion that insecure property rights reflect distributional conflicts in the host country population, and that appropriate development support can shift agents’ distributional interests in favor of foreign firms.

Effective Governance through Decentralized Soft Implementation: The OECD Guidelines for Multinational Enterprises

Botnia S.A./Metsä-Botnia Oy's construction of the Orion pulp mill in Uruguay raised concerns regarding violations of national, regional, and international law with regard to social and environmental protection. On 18 April 2006, the Center for Human Rights and Environment (CEDHA), an Argentinean non-governmental organisation, submitted to Finland's National Contact Point (NCP) a “specific instance” regarding the possible non-compliance of Botnia S.A. (a Finnish enterprise) with the OECD Guidelines for Multinational Enterprises (OECD Guidelines for MNEs, Guidelines) when building the envisaged pulp mill in Uruguay. According to the Center for Human Rights and Environment, Botnia S.A. violated the OECD Guidelines for MNEs especially with respect to Chapter II “General Policies”, Chapter III “Disclosure”, Chapter V “Environment” and Chapter VI “Bribery”. Specific instances concerned with related issues were filed by the Center for Human Rights and Environment with the Swedish and Norwegian NCPs against Nordea, a leading financial services group of the Nordic and Baltic Sea area, for possible financing of Botnia S.A.'s pulp mill project and against the Finnish state bank Finnvera for providing export guarantees to Botnia S.A. Other fora that have in the meantime become involved in the issue are the International Court of Justice and member institutions of the World Bank Group, the International Finance Corporation and the Multilateral Investment Guarantee Agency.

International Law and the Settlement of Investment Disputes Relating To China

This article examines how international investment law can be used to resolve investment disputes in China. After a general overview over the basic structure of international investment law, it explores the international legal rules applicable to foreign investors in China and Chinese investors in third countries. It focuses on China’s obligations under the Convention on the Settlement of Investment Disputes between States and Nationals of other States; the Convention establishing the Multilateral Investment Guarantee Agency, the WTO/GATT-regime and bilateral investment treaties. It thereby illustrates China’s cautious approach to international arbitration and other international standards relating to the protection of foreign investors and the current trend in Chinese politics to turn to international law to protect its investors in third countries. The article concludes that—also caused by increasing Chinese outward investment—the international investment regime relating to China has left its infant stage and provides remedies for foreign investors in China and Chinese investors abroad.