A Proposal on How the Regulator Should Set Minimum Interest Rate Guarantees in Participating Life Insurance Contracts

• Author: Hato Schmeiser,Joël Wagner
• DOI: http://doi.org/10.1111/jori.12036
• Published date: 01 September 2015
• Date: 01 September 2015

©2014 The Journal of Risk and Insurance. Vol.82, No. 3, 659–686 (2015).

DOI: 10.1111/jori.12036

A Proposal on How the Regulator Should Set

Minimum Interest Rate Guarantees in Participating

Life Insurance Contracts

Hato Schmeiser

Jo¨

el Wagner

Abstract

We consider a contingent claim model framework for participating life in-

surance contracts and assume a competitive market with minimum solvency

requirements as provided by Solvency II. In a first step, the implications of

the regulator’s imposing a particular interest rate guarantee on the insurer’s

asset allocation are analyzed in a referencesituation. We study the sensitivity

of the interaction between the interest rate guarantee and the asset allocation

when the risk-free interest rate changes. Particular attention is paid to the

current market situation where the guaranteed interest rate is often close to

the risk-free interest rate. In a second step, we assess at what level the interest

rate guarantee should be set by the regulator in order to maximize policy-

holders’ utility. We show that the results yielded by the proposed concept

to derive an optimal value for the interest rate guarantee are very stable for

various model parameters.

Introduction

A minimum interest rate guarantee and participation in the annual return of the insur-

ance company’s asset portfolio are the two core components in traditional endowment

contracts most popular in the German-speaking countries. Both elements are offered

in so-called participating life insurance contracts and are in general regulated by the

insurance supervisory authority. In current contracts offered, minimum interest rate

guarantees are based on the savings premium and usually provided on a year-by-year

basis (cliquet-style) for the whole contract duration. Contracts often have a very long

duration with savings accumulation periods of over 40 years.1In view of (higher)

equity capital requirements under new solvency regulations (see, e.g., Solvency II in

Hato Schmeiser and Jo¨

el Wagner are with the Institute of Insurance Economics, University of

St. Gallen, Kirchlistrasse 2, CH-9010 St. Gallen, Switzerland. The authors can be reached via

e-mail: hato.schmeiser@unisg.ch and joel.wagner@unisg.ch. The authors would like to thank

the anonymous referees for their comments helping to improve earlier versions of the paper.

1Contracts are closed for a period averaging almost 30 years in the German market, even though

about half of the contracts are canceled before maturity (see BVZL International Secondary

Markets for Life Insurance, www.bvzl.de).For the United States, Klein and Butala (2004) state

that policies and their long-term guarantees often last more than 50 years.

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the European Union) and the current capital market situation with low-return invest-

ment opportunities, long-term interest rate guarantees in life insurance contracts are

becoming more and more difficult to manage. Current discussions in the industry

include the introduction of time limits for the guarantees (e.g., for the first 10 years)

or a relative definition of the guarantees that renders them adjustable throughout the

contract duration (e.g., as a percentage of the return on government bonds) (see also

Heinen, 2011). Recently, German life insurance group N¨

urnberger announced its in-

tention to develop a new type of conventional insurance contracts without an ex ante

fixed interest rate guarantee for the whole contract duration (see Fromme, 2011).

The guaranteed interest rate and policyholder participation are common examples

of implicit option elements in standard type policies issued in the United States,

Europe, and Japan (see Grosen and Jorgensen, 2000). If these guarantees are not

properly valued and accordingly hedged, they may represent a hazardfor the insurer

solvency. From the late 1980s through the 1990s a large number of massive life

insurer defaults occurred, including, for example, the First Executive Corporation

(United States), Garantie Mutuelle des Fonctionnaires (France), and Nissan Mutual

Life (Japan). More recently, in the early 2000s the British life insurer Equitable Life

had to stop taking new business and German Mannheimer Lebensversicherung ran

into financial distress.2In these cases, the companies were unable to meet obligations

that arose from investment guarantees they provided to their customers.

As a response to the insolvency threat to insurance companies these return guarantees

are now widely regulated by local authorities. The underlying trigger for the defaults

is typically a change in capital market returns when market interest rates fall to par-

ticularly low levels compared to the guaranteed rates. Following 69 insolvencies in

the United States in the years 1987–1989, regulation was enacted in 1990 requiring,

inter alia, higher contributions to mandatory securities valuation reserves (see Wright,

1991, pp. 91–95), with the effect that policies with high embedded guarantees were

less commonly offered. In the following years, further regulatory and accounting ini-

tiatives were launched, evidence of heightened concern over interest rate guarantees

(see, e.g., Grosen and Jorgensen, 2002, p. 66). Since 1992, European Union life insur-

ance directives (see European Union, 1992, Art. 18, confirmed by European Union,

2002, Art. 20) have defined upper bounds for interest rate guarantees. Grosen and

Jorgensen (2002,Table 1) summarize maximum rates for several countries: while the

United States has not set a maximum rate, European Union countries as well as Japan

have established such limits (see, e.g., Cummins, Miltersen, and Persson, 2007; Eling

and Holder, 2013, for a detailed comparison).3

2For a detailed review of bankruptcies due to implicit policy guarantees, see Wright (1991),

Briys and de Varenne (1997), Ballotta and Haberman (2003), Ballotta, Haberman, and Wang

(2003), or Grosen and Jorgensen (2002) and the references cited therein.

3Aside from regulation on guaranteed rates and policyholder participation, local solvency cap-

ital requirements and contributions to guaranty schemes apply. A broad overview of different

countries’ solvency regulationcan be found, for example, in Eling, Schmeiser, and Schmit (2007,

Table1). Schmeiser and Wagner (2013, Table1) give an international review of guaranty funds

in force.