This paper aims to theoretically examine the effects of regulatory policyholder protection on spread behavior and default probability of a life insurance company.
The authors construct a contingent claim model for the valuation of the equity of a life insurance company. Then, they extend it to model default risk measures associated with a more appropriate behavioral mode of strategic invested asset rate-setting under regulation.
The findings established that the optimal insurer interest margin is explicitly modeled by a spread between the loan rate and the required guaranteed rate of the company. The effect of the guaranteed rate on the insurer interest margin is positive when the barrier is low, whereas it is negative when the barrier is high. As the barrier increases, the positive effect of the guaranteed rate on the default risk is increased, the negative effect of the participation on the insurer interest margin is decreased and the positive effect of the participation on the default risk is decreased.
Several results derived that should be of interest to investors, analysts, supervising agencies and policymakers. For example, policyholders protected by increasing the guaranteed rate may create a higher risk for the life insurance company to meet its obligations.
The authors’ approach is a significant departure from the existing literature; they differentiate among path-dependent, barrier options and suggest that the life insurance company’s defaults are more commonly triggered by regulatory responses than debt default.
