infonet-economy

The purpose of this paper is to provide a detailed analysis of industry loss warranties (ILWs), an alternative risk transfer instrument which has become increasingly popular throughout the last few years.

The authors first point out key characteristics of ILWs important to investor and cedent, including transaction costs, moral hazard, basis risk, counterparty risk, industry loss index, and regulation. Next, the authors present and discuss the adequacy of actuarial and financial approaches for pricing ILWs, as well as the aspects of basis risk. Finally, drivers of demand and associated models frameworks from the purchaser's viewpoint are studied.

Financial pricing approaches for ILWs are highly sensitive to input parameters, which is important given the high volatility of the underlying loss index. In addition, the underlying assumption of replicability of the claims is not without problems. Due to their simple and standardized structure and the dependence on a transparent industry loss index, ILWs are low-barrier products, which can also be offered by hedge funds. In principle, traditional reinsurance contracts are still preferred as a measure of risk transfer, especially since these are widely accepted for solvency capital reduction. However, the main important impact factor for the demand of ILWs from the perspective of market participants, i.e. large diversified reinsurers and hedge funds, is the lower price due to rather low transaction costs and less documentation effort. Hence, ILWs are attractive despite the introduction of basis risk and the still somewhat opaque regulatory environment.

An important issue for future research is how reinsureds deal with the basis risk inherent in ILWs. Another central point is the development of a European industry loss index and the creation of an exchange platform to enable an even higher degree of standardization and a faster processing of transactions.

ILWs feature an industry loss index to be triggered, and, in some cases, a double-trigger design that includes a company indemnity trigger. ILW contracts belong to the class of alternative risk transfer instruments that have become increasingly popular, especially in the retrocession reinsurance market. There has been no comprehensive analysis of these instruments in academic literature to date. Consequently, the authors believe that this paper provides a high degree of originality.

Participating life insurance contracts typically contain various types of implicit options. These implicit options can be very valuable and can thus represent a significant risk to insurance companies if they practice insufficient risk management. Options become especially risky through interaction with other options included in the contracts, which makes their evaluation even more complex. This article provides a comprehensive overview and classification of implicit options in participating life insurance contracts and discusses the relevant literature. It points out the potential problems particularly associated with the valuation of rights to early exercise due to policyholder exercise behavior. The risk potential of the interaction of implicit options is illustrated with numerical examples by means of a life insurance contract that includes common implicit options, i.e., a guaranteed interest rate, stochastic annual surplus participation, and paid-up and resumption options. Valuation is conducted using risk-neutral valuation, a concept that implicitly assumes the implementation of risk management measures such as hedging strategies.

In an environment of increasingly frequent consolidation activity, the advantages and risks of corporate diversification are of great interest to regulatory authorities, financial group management and management of individual group entities. In general, conglomeration leads to a diversification of risks (the diversification benefit) and to a decrease in shareholder value (the conglomerate discount). Diversification benefits in financial conglomerates are typically derived without accounting for reduced shareholder value, even though a comprehensive analysis requires competitive conditions within the conglomerate, i.e.shareholders and debtholders receive risk-adequate returns

The aim of this article is to identify fair equity-premium combinations for non-life insurers that satisfy solvency capital requirements imposed by regulatory authorities. In particular, we compare "target capital" derived using the "value at risk" concept as planned for Solvency II in the European Union with the "tail value at risk" concept as required by the Swiss Solvency Test. The model framework uses Merton's jump-diffusion process for the market value of liabilities and a geometric Brownian motion for the asset process; valuation is conducted using option pricing theory. In this setting, we study the impact of model parameters and corporate taxation on fair pricing, solvency capital requirements, and shortfall probability for different safety levels measured by the default put option value. We show that even though corporate taxes can have a substantial impact on pricing and capital structure, they do not affect capital requirements if the safety level is retained before and after taxation.

Most life insurance contracts embed the right to stop premium payments during the term of the contract (paid-up option). Thereby, the contract is not terminated but continues with reduced benefits and often provides the right to resume premium payments later,
thus reincreasing the previously reduced benefits (resumption option). In our analysis, we start with a basic contract with two standard options, namely, an interest-rate guarantee and cliquet-style annual surplus participation. Next, we include, in addition to the
features of the basic contract, a paid-up and resumption option in the framework. We do not base our pricing on assumptions about particular exercise strategies, but instead assess the risk potential by providing an upper bound to the option price which is independent
of the policyholder's exercise behavior. This approach provides important information to the insurer about the potential hazard of offering the paid-up and resumption option. Further, the approach allows an analysis of the impact of guaranteed interest rate, annual surplus participation, and investment volatility on the values of the premium payment options.

Fair pricing of embedded options in life insurance contracts is usually conducted by using the appropriate concept of risk-neutral valuation. This concept assumes a perfect hedging strategy, which insurance companies can hardly pursue in practice. In this paper, we extend
the risk-neutral valuation concept with a risk measurement approach. We accomplish this by first calibrating contract parameters that lead to the same market value using risk-neutral valuation. We then measure the resulting risk assuming that insurers do not follow perfect hedging strategies. As the relevant risk measure, we use lower partial moments, comparing shortfall probability, expected shortfall, and shortfall variance. We show that even when contracts have the same market value, the insurance company's risk can vary widely, a finding
that allows us to identify key risk drivers for participating life insurance contracts.

Common features in life insurance contracts are an interest rate guarantee and policyholder participation in the returns of insurers' reference portfolio, which can be of substantial value. The aim of this paper is to analyze the model risk involved in pricing and risk assessment that arises from the process specification of the reference portfolio. This is, in general, the most important source of model risk and is analyzed by comparing results from the standard Black-Scholes setting with a Lévy-type model based on a Normal Inverse Gaussian process. We focus on the dependence of the insurer's insolvency risk associated with fair contracts on the specification of the underlying asset process using lower partial moments. We show that a misspecification of the underlying stochastic asset model may not only result in serious mispricing, but also lead to an inadequate assessment of insurers' shortfall risk. Model risk can thus imply substantial solvency risk for insurance companies.