Solvency Regulation Research Articles

Catastrophe insurance and solvency regulation

Catastrophe insurance and solvency regulation

The Use of Retrocession by Retakaful operators: An Analysis from Shariah Perspective

In Malaysia, the insurance and takaful sector is under the purview of the Central Bank of Malaysia, and the same goes for reinsurance and retakaful operations. However, due to the country's dual financial system i.e. the conventional and Islamic financial system, conventional reinsurance and retakaful, fall under different laws. The conventional reinsurance is regulated under the Financial Services Act (2013) while the takaful and retakaful by the Islamic Financial Services Act (2013). Undoubtedly, the takaful industry is expanding in the Malaysian market today by leaps and bounds. Retakaful acts in the same way as takaful, providing (re)takaful arrangement for their policyholders. The survival of the takaful operator is heavily influenced by the retakaful operators. The takaful operator will distribute some portion of their risks that they cannot bear to a retakaful operators. However, the retakaful operators are currently unable to cover the entire risk that were ceded by the takaful operators due to lack of retakaful operators in the market, as well as very limited capital, inadequate accumulated funds, and regulatory solvency issues. At the same time, retakaful operators also face challenges in meeting their commercial goals. They, in turn, use tools such as retrocession to overcome their impending challenges. This paper aims to analyse the importance of retrocession to the retakaful company from a Shariah perspective. The research is timely as not much research has been carried out on Retakaful operations in Malaysia. There is also limited discussion related to the business models of retakaful, as well as no specific guidelines focusing on retakaful itself. Therefore, a qualitative approach is suitable for the purpose of exploring such new areas. Besides, Retakaful industry is considered relatively new compared to reinsurance.

Optimal investment and reinsurance to reach a bequest goal with random time solvency regulation

ABSTRACT This paper studies optimal investment and proportional reinsurance policies for an insurer with Markov regime-switching model and random time solvency regulation. The goal of the insurer is to maximise the probability that its wealth exceeds a predetermined level l before the regulatory time arrives. By constructing an auxiliary control problem without regime switching, together with the classical results on Hamilton-Jacobi-Bellman (HJB) equation and fixed-point method, we prove the regularity of the value function. When the current state of the Markov chain is given, we found that the optimal policies for an insurer in a multiple-regime market is the same as those in a single-regime market. Explicit optimal policies can be derived when the premium is calculated by the expectation principle. For more general cases, numerical schemes for value functions and feedback optimal policies are given by the Markov chain approximating method.

Sectoral Asset Concentrations and Insurance Solvency Regulation

Historical evidence, like the global financial crisis from 2007–2009, highlights that sectoral asset concentrations can play an important role in the solvency of insurers. Yet, current regulatory frameworks, such as the U.S. risk-based capital (RBC) framework, neglect sectoral asset concentrations in the determination of capital requirements, potentially underestimating the asset portfolio’s systematic loss exposure and reducing incentives for corresponding risk mitigation. By creating a detailed data sample of U.S. insurers’ asset holdings from 2009 to 2018 by means of their statutory filings, we find that insurers concentrate their assets particularly toward the financial, public, and real estate sector and that sectoral asset concentrations toward the public sector are associated with improved solvency, while concentrations toward the real estate sector weaken solvency. Our findings can serve as a starting point to revise current regulatory practices, particularly in terms of creating proactive incentives for insurers to mitigate the accumulation of systematic risk exposures associated with sectoral asset concentrations.

Legal Implications of Liberalisation and Globalisation of Insurance Sector

The liberalization and globalization of the insurance sector have had significant legal implications. The liberalization and globalization of the insurance sector have been driven by the increasing interconnectedness of economies and the desire to promote competition and efficiency in the market. This process involves opening up domestic insurance markets to foreign companies and removing barriers to entry for new players. As a result, there has been a surge in cross-border investments, mergers, and acquisitions, leading to the expansion of multinational insurance companies. From a legal perspective, the liberalization and globalization of the insurance sector have necessitated changes in regulatory frameworks and the harmonization of laws across jurisdictions. Governments have had to revise their domestic insurance laws to accommodate the entry of foreign insurers and ensure a level playing field for all participants. This includes revisiting licensing requirements, solvency regulations, consumer protection laws, and dispute resolution mechanisms. The liberalization and globalization of the insurance sector have had far-reaching legal implications. These include the need for regulatory reform, international cooperation, and harmonization of laws. Key words: Constitution, solvency, globalization, self-government and Nationalisation

Pareto-optimal reinsurance with default risk and solvency regulation

AbstractThis paper studies a Pareto-optimal reinsurance problem when the contract is subject to default of the reinsurer. We assume that the reinsurer can invest a share of its wealth in a risky asset and default occurs when the reinsurer's end-of-period wealth is insufficient to cover the indemnity. We show that without the solvency regulation, the optimal indemnity function is of excess-of-loss form, regardless of the investment decision. Under the solvency regulation constraint, by assuming the investment decision remains unchanged, the optimal indemnity function is characterized element-wisely. Partial results are derived when both the indemnity function and investment decision are impacted by the solvency regulation. Numerical examples are provided to illustrate the implications of our results and the sensitivity of solution to the model parameters.

Beyond death: The impact of a population-wide health shock on life insurance

Population-wide health shocks, for example, pandemics, affect life insurance owners beyond their health impact. This paper considers joint impacts of their surrender behavior adaptions and mortality rise following a population-wide health shock on insurance pricing. We build a model that captures both more surrenders of contracts to meet unexpected liquidity needs and less financially beneficial surrenders to keep insurance protection after the shock. Unlike the systemic mortality rise impact that turns out to be negligible, we find that policyholders’ surrender behavior adaptions substantially devalue policies with increasing emergency surrenders being the main driver. Regulatory solvency protection partly restrains the devaluation.

Capital requirements and claims recovery: A new perspective on solvency regulation

AbstractProtection of creditors is a key objective of financial regulation. Where the protection needs are high, that is, in banking and insurance, regulatory solvency requirements are an instrument to prevent that creditors incur losses on their claims. The current regulatory requirements based on value at risk (V@R) and average value at risk (AV@R) limit the probability of default of financial institutions, but they fail to control the size of recovery on creditors' claims in the case of default. We resolve this failure by developing a novel risk measure, recovery V@R. Our conceptual approach is flexible and allows the construction of general recovery risk measures for various risk management purposes. We provide detailed case studies and applications. We show that recovery risk measures can be used for performance‐based management of business divisions of firms and discuss how to calibrate recovery risk measures to historical regulatory standards. Finally, we analyze how recovery risk measures react to the joint distributions of assets and liabilities on firms' balance sheets and compare the corresponding capital requirements with the current regulatory benchmarks based on V@R and AV@R.

Risk pooling and solvency regulation: A policyholder's perspective

Risk pooling and solvency regulation: A policyholder's perspective

Surrender contagion in life insurance

Modern life insurance policies embed a surrender option that entitles policyholders to terminate their policy early for its cash value. Mass surrenders–spiking surrenders of life insurance policies within a short period–are widely documented prior to many life insurer failures, but their impacts on insurers are rarely quantified. This paper builds a model of mass surrenders in a heterogeneous pool consisting of a minority of financially guided policyholders who make rational surrender decisions and a majority of individual policyholders who are subject to herd. By revising the self-excitation in the Hawkes process to a contingent event-accumulation-excitation, we introduce a history-dependent surrender process for the individuals whose contagious behavior can be triggered contingent on past surrenders becoming salient. We then incorporate it into a life insurance pricing framework and study mass surrenders’ impacts on contract valuation and default risk of the insurer, allowing for its structural default under regulatory solvency intervention. Our numerical results show that while contagion aligns individual policyholders’ surrender behavior with the optimal surrender of financially guided ones, it jeopardizes their financial positions in favor of equity holders. Surprisingly, surrender contagion only mildly enlarges an insurer’s bankruptcy rate, which is not driven by strict solvency regulation. Despite its public perception of posing a significant risk to insurers as similar to a bank run, surrender contagion does not critically threaten insurers’ solvency: To prevent insurers’ bankruptcies, their investment riskiness and leverage pose more of a concern to regulators.

Towards a Global Solvency Model in the Insurance Market: A Qualitative Analysis

In recent years, there has been a change in the main regulations governing the solvency of the world’s main insurance markets. Sustainability is an issue that is becoming increasingly important among to the various stakeholders in the insurance industry. It is a complex concept that has many different dimensions that can be included in these regulations, allowing for a more sustainable solvency. The paper uses a qualitative model previously designed and tested in the literature to analyse the solvency regulations of the European Union, United States of America, China, Australia, Brazil and South Africa and determine their level of convergence. It also links the criteria set out in these models to the dimensions of sustainability in order to determine the degree of sustainability of solvency systems and the questions that regulators will need to consider in the near future in order to achieve more sustainable solvency.

Determinants of CoCo issuance: liquidity and risk incentives

PurposeThis paper aims to study the impact of (regulatory and nonregulatory) liquidity on contingent convertible (CoCo) issuance and the relationship between CoCos and asset quality.Design/methodology/approachThe analysis of this study comprises two stages. In the first stage, the authors used a logit model to test whether banks with riskier assets as well as lower solvency and (regulatory and nonregulatory) liquidity are more likely to issue CoCos. In the second stage, the authors used univariate analysis and fixed effects regression to measure the impact of Additional Tier 1 (AT1) CoCos on the quality of the issuer’s assets.FindingsThe study shows that regulatory liquidity ratios are negatively related to CoCo issuance. This study also finds that the likelihood to issue CoCo is higher when banks have lower regulatory capital or are less risky. Asset quality is found to not change significantly after the issuance. All in all, these results suggest that while solvency regulation is primarily regarded as the main motivation for CoCo issuance, liquidity regulation also matters.Research limitations/implicationsDespite the fact that CoCos have been emerging as an alternative way to help banks meet regulatory capital requirements, the paper argues that the relation between liquidity regulation and CoCos should be taken into account.Originality/valueThis study presents an empirical analysis on the CoCos instrument, focusing on the relationship between AT1 CoCos and liquidity regulation. Therefore, it serves to fill a gap in the literature on the underlying forces behind CoCo issuance. Moreover, this study measures the impact of AT1 CoCos issuance on bank risk, particularly on the quality of the issuer’s assets.

Exploratory Analysis of Solvency Regulations in the Three Main Latin American Insurance Markets

Objetivo – Este documento examina la adecuación de los diferentes sistemas de regulación de la solvencia de las compañías de segurosReferencial teórico – El sector de los seguros está inmerso en un proceso global de cambio. Existen diferentes sistemas y cada uno de ellos se enfrenta a la insolvencia de forma diferente, aunque todos proporcionan un capital óptimo para hacer frente a situaciones indeseables. Este estudio se centra en América Latina, dondeel sector es cada vez más importante. Brasil, México y Argentina son los países más relevantes en cuanto a volumen de primas anuales.Metodología – Este trabajo utiliza el marco diseñado por Cummins et al. (1994) para ver si son adecuados para reducir el número de insolvencias.Resultados – El examen de la regulación en estos países muestra que todos han sido reformados, siguiendo la tendencia del sector de los seguros en la última década, aunque el desarrollo legislativo es mayor en algunos países que en otros. La implicación del sistema debe producirse a dos niveles: por parte de la aseguradora, con la autoevaluación periódica de los riesgos, y por parte del regulador, con la revisión periódica del sistema en su conjunto.Implicaciones prácticas y sociales de la investigación – Este trabajo contribuye a la literatura proponiendo las líneas de trabajo necesarias para la globalización de la regulación del sector asegurador en América LatinaContribuciones – La principal conclusión es que los sistemas de regulación deben aumentar el enfoque cualitativo de la gestión de riesgos, no sólo en el número de cálculos, sino también en el aumento de la gobernanza, la transparencia y el control de riesgos.Palabras clave: Supervisión de seguros, requisitos de capital, gestión de riesgos, solvencia, estabilidad de los seguros.

Периодическая процентная ставка по кредиту модели Нэша с ограничением платежеспособности Базель II

This paper introduces multi–period loan interest rate Nash game models in the banking sector under regulatory solvency constraints. By taking solvency constraint as Basel II and modelling economic condition as AR(1) process, we obtain results regarding the existence of loan interest rate equilibrium. A sensitivity analysis for the solvency constraint model and some numerical results are presented.

Tail index-linked annuity: A longevity risk sharing retirement plan

This paper proposes an innovative retirement product focusing on longevity risk sharing, a contract we refer to as tail index-linked annuity (TILA). Specifically, the proposed TILA pays out variable annual payments, which will be equal to a regular nominal amount when a reference survival index is lower than a predetermined threshold (i.e. normal evolution of longevity risk), and a reduced, index-dependent payment when the threshold is passed (i.e. highly unfavorable evolution of longevity risk). The proposed TILA aims at not only improving the benefits of the policyholders, which has been the focus in recent literature on innovative retirement products, but also reducing the longevity risk exposure of the insurer, particularly for advanced retirement ages. Using real-world mortality data and a stochastic multi-population mortality model, we find that the proposed TILA leads to higher expected lifetime utility than regular annuities for policyholders with different degrees of risk aversions. Meanwhile, numerical analysis shows that the proposed TILA could greatly mitigate the solvency risk of the insurer, leading to a substantially lower loss probability and expected (tail-) loss than regular annuities in the presence of a longevity shock, and therefore could reduce the insurer's required solvency capital under the latest solvency regulations.

Solvency Regulation—An Assessment of Basel III for Banks and of Planned Solvency III for Insurers

Basel III, regulating the solvency of banks, is to be fully implemented by 2027 while Solvency III directed at insurers is being prepared. In view of past experience, it will be closely modelled after Basel III. This raises two questions. (i) Will Basel III and Solvency III be more successful than their predecessors? (ii) Is it appropriate to continue regulating the solvency of banks and insurers in the same way? The first question is motivated by an earlier finding that Basel I and II risked inducing more rather than less risk-taking by banks, which also holds for Solvency I and II w.r.t. insurers. The methodology applied was to determine the slope of an endogenous perceived efficiency frontier (EPEF) in (μ^,σ^)-space derived from banks’ and insurers’ optimal adjustment to exogenous changes, in expected returns dμ¯ and volatility dσ¯ on the capital market. Both Basel I and II and Solvency I and II neglected the impact of these developments on banks’ and insurers’ EPEF. This neglect had the effect of steepening the EPEF, causing senior management to opt for an increased rather than reduced value of σ^, and hence a lower solvency level. This issue is resolved by Basel III (Principle 5), which requires banks to take developments in the capital market into account in the formulation of their business strategies designed to ensure solvency. In combination with increased capital requirements, this is shown to result in a reduced slope of their EPEF and hence a reduced risk exposure. However, planned Solvency III may cause the EPEF of highly capitalized insurance companies to become steeper, with a concomitant decrease in their risk-taking and an increase of their solvency level. The second question, concerning the appropriateness of the uniformity of solvency regulation directed at banks and insurers, arises because the parameters determining the slope of the respective EPEF are found to crucially differ. Therefore, the uniformity of Basel and Solvency norms creates the risk of a mistaken regulatory focus.

Loan interest rate Nash models with solvency constraints in the banking sector

ABSTRACT This paper attempts to study loan interest rate Nash game models in the banking sector under regulatory solvency constraints. By taking solvency constraints as Basel I, Basel II, and Expected Shortfall (ES), we obtain results regarding the existence of loan interest rate equilibrium. A sensitivity analysis for solvency models and some numerical results are presented. Numerical results show that the weighted loan interest rate of the Mongolian banking system is consistent with the base case of the theoretical weighted loan interest rate corresponding to the Nash equilibrium.

Machine learning techniques in nested stochastic simulations for life insurance

AbstractThe insurance regulatory regime introduced in the European Union by the “Solvency II” Directive 2009/138, that has become applicable on 1 January 2016, is aimed to safeguard policyholders and beneficiaries by requiring insurance undertakings to hold own funds able to cover losses, in excess to the expected ones, at the 99.5% confidence level, over a 1‐year period. In order to assess risks and evaluate the regulatory Solvency Capital Requirement, undertakings should compute the probability distribution of the Net Asset Value over a 1‐year period, with a financially inspiredmarket consistentapproach. In life insurance, given the peculiarities of the contracts, the valuation of the Net Asset Value distribution requires anested Monte Carlosimulation, which is extremely time‐consuming. Machine learning techniques are considered a promising candidate to reduce the computational burden of nested simulations. This work investigates the potential of well‐established methods, such asdeep learning networksandsupport vector regressors, when applied to the valuation of the Solvency Capital Requirement ofparticipating life insurance policies, by empirically assessing their effectiveness and by comparing their efficiency and accuracy, also w.r.t. the “traditional”least squares Monte Carlotechnique. The work aims also to contribute to the global process of renewal of the European insurance industry, where Solvency II has made the board of directors fully responsible of the choice of evaluation techniques and algorithmic processes, under the periodic monitoring of national supervisory authorities.

Pareto-optimal Reinsurance with Default Risk and Solvency Regulation

This paper studies an optimal reinsurance problem of Pareto-optimality when the contract is subject to default of the reinsurer. We assume that the reinsurer can invest a share of its wealth in a risky asset and default occurs when the reinsurer's end-of-period wealth is insufficient to cover the indemnity. We show that without the solvency regulation, the optimal indemnity function is of excess-of-loss form, regardless of the investment decision. We model solvency regulation as a constraint on the probability of default. Under solvency regulation, by assuming the investment decision remains the same as in the unconstrained solution, the optimal indemnity function is derived element-wisely. Partial results are given when the indemnity function and investment decision are jointly constrained by the solvency regulation. Numerical examples are provided to illustrate the implications of our results and the sensitivity of the solutions to the model parameters.

Capital Requirements and Claims Recovery: A New Perspective on Solvency Regulation

Protection of creditors is a key objective of financial regulation. Where the protection needs are high, i.e., in banking and insurance, regulatory solvency requirements are an instrument to prevent that creditors incur losses on their claims. The current regulatory requirements based on Value at Risk and Average Value at Risk limit the probability of default of financial institutions, but fail to control the size of recovery on creditors' claims in the case of default. We resolve this failure by developing a novel risk measure, Recovery Value at Risk. Our conceptual approach can flexibly be extended and allows the construction of general recovery risk measures for various risk management purposes. By design, these risk measures control recovery on creditors' claims and integrate the protection needs of creditors into the incentive structure of the management. We provide detailed case studies and applications: We analyze how recovery risk measures react to the joint distributions of assets and liabilities on firms' balance sheets and compare the corresponding capital requirements with the current regulatory benchmarks based on Value at Risk and Average Value at Risk. We discuss how to calibrate recovery risk measures to historic regulatory standards. Finally, we show that recovery risk measures can be applied to performance-based management of business divisions of firms and that they allow for a tractable characterization of optimal tradeoffs between risk and return in the context of investment management.