The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure

• Author: Joël Wagner,Hato Schmeiser
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01474.x
• Date: 01 June 2013
• Published date: 01 June 2013

C

The Journal of Risk and Insurance, 2013, Vol. 80, No. 2, 273-308

DOI: 10.1111/j.1539-6975.2012.01474.x

THE IMPACT OF INTRODUCING INSURANCE GUARANTY

SCHEMES ON PRICING AND CAPITAL STRUCTURE

Hato Schmeiser

Jo¨

el Wagner

ABSTRACT

The introduction of an insurance guaranty scheme can have significant in-

fluence on the pricing and capital structures in a competitive market. The

aim of this article is to study this effect on competitive equity–premium

combinations while considering a framework with policyholders and equity

holders where guaranty fund charges arevolume-based, as levied in existing

schemes. Several settings with regard to the origin of the fund contributions

are assessed and the immediate effects on the incentives of the policyhold-

ers and equity holders are analyzed through a one-period contingent claim

approach. One result is that introducing a guaranty scheme in a market with

competitive conditions entails a shift of equity capital towards minimum

solvency requirements. Hence, adverse incentives may arise with regard to

the overall security level of the industry.

INTRODUCTION

In many countries, insurance guaranty schemes are in place to cover a part of the

obligations of insolvent insurers. Over recent decades, guaranty funds have been in-

troduced when a country’s insurance sector has assisted, in a cooperative effort with

the regulator, in the liquidation of one (or more) defaulting companies. One example

is German life insurer Mannheimer Lebensversicherung (344,000 life insurance con-

tracts), which was in financial distress and then taken over in 2003 by a funded rescue

company named Protektor. Today, Protektor acts as an insurance guaranty fund and

a general rescue company for the German life insurance industry.1Recentturbulence

Hato Schmeiser and Jo¨

el Wagner are with the Institute of Insurance Economics, University

of St. Gallen, Kirchlistrasse 2, CH-9010 St. Gallen. The authors can be contacted via e-mail:

hato.schmeiser@unisg.ch and joel.wagner@unisg.ch, respectively. The authors are thankful to

the participants of the World Risk and Insurance Economics Congress (Singapore, 2010), of

the Annual Congress of the German Insurance Science Association (Berlin, 2011), and of the

ASTIN and AFIR Colloquia (Madrid, 2011) for their helpful discussions in respect to the ideas

and the concept presented in the paper. In addition, the authors would like to thank the three

anonymous referees for their helpful suggestions and comments on an earlier draft of the

manuscript.

1Other considerable examples in Europe include the bankruptcy of the Danish insurer Plus

Forsikring in 2002, Britain’s Independent Insurance in 2001, and France’s Europavie in 1997.

273

274 THE JOURNAL OF RISK AND INSURANCE

in the financial markets highlighted the need for a review of the current regulations.

The latter include solvency measurement (e.g., European Union Solvency II), and the

reexamination, or introduction where they do not exist, of customer guaranty sys-

tems, as well as schemes for the banking and the insurance fields. While the review

of banking deposit insurance systems in the European Union led to higher caps over

the last year and months with homogenization by the end of 2011 (see, e.g., ECOFIN

Council, 2008), the insurance sector has no comparable comprehensive system. It is

undoubtedly difficult to justify the cost of insolvencies falling on taxpayers and so-

ciety as a whole, even if adequate supervision can reduce the likelihood of insurers

defaulting. A recent example, albeit in which the core insurance business may not

have been the main trigger, is the bailout of insurance giant AIG in 2008, where it is

still unclear whether taxpayers will ever be repaid in full.

As part of the European Union’s response to the economic and financial crisis,2the

European Commission has announced a review of the adequacy of existing guaranty

schemes in the insurance sector. The initiative, based on work undertaken since 2001,

led to a White Paper in 2010, setting out a European solution for insurance guaranty

schemes (European Commission, 2010b).3Whereas in the United States each state has

two guaranty associations, one for life insurance and the other for property–liability

insurance, with both associations being incorporated in national organizations, the

insurance guaranty scheme landscape in Europe is heterogeneous. An extensive anal-

ysis of existing guaranty schemes in the European Union in 2007 (Oxera, 2007, p. 7)

finds that 13 countries out of the 27 Member States had introduced relevant schemes

supporting either the life or nonlife insurance sectors, or part of these.4The guaranty

scheme systems of the various countries are very similar, but differ in extent. From a

(cross-border) European perspective, many questions arise when facing the challenge

of unification, or of the fund volume needed (European Commission, 2010a). The lack

of harmonized insurance guaranty scheme arrangements within the European Union

hinders effective and equal consumer protection. In light of the lessons drawn from

the recent crisis, the development of harmonized guaranty schemes could contribute

to remedying the existing deficiencies, while not impeding the operation of the inter-

nal insurance market by distorting cross-border competition. It is thus worthy of note

that by 2010 around 26 percent of all life insurance policies in the European Union and

56 percent of all nonlife insurance policies were unprotected (European Commission,

2010a).

Further case descriptions and figures regarding the number of insurance failures, including

the United States, can be found, for example, in Oxera (2007, Section 4.5f).

2See the European Union’s online portal http://ec.europa.eu/financial-crisis.

3A summary of the comments from the public consultation on the White Paper has been

published in February 2011 (European Commission, 2011). Most respondents are in favor

of measures at European Union level in order to harmonizing national insurance guaranty

schemes.

4In addition, other protection mechanisms besides the introduction of an insurance guaranty

fund are discussed in Oxera (2007, Section 3). In this context, the reasons for the installation

of an insurance guaranty fund are given and the desired market outcomes, as well as the

potential wrong incentives and transaction costs, are derived (Oxera, 2007, Sections 3.1 to 3.5).

IMPACT OF INTRODUCING INSURANCE GUARANTY SCHEMES 275

One important consideration is that most of the existing insurance guaranty fund

schemes charge premiums that are not directly linked to insurer risks.5Thus, one

can expect adverse incentives for insurers and cross-subsidization between market

players. This has been discussed extensively in the literature. An early analysis by

Cummins (1988) affirms that well-designed insurance guaranty funds should demand

risk-based premium payments in order to avoid adverse incentives. With respect to

regulation implications, pricing aspects are further discussed by, for example, Cum-

mins and Lamm-Tennant (1994) and Cummins and Sommer (1996). Duan and Yu

(2005) extend the Cummins (1988) model to a multiperiod setting, calculating insur-

ance guaranty premiums in the presence of risk-based capital regulations. The issue

of a system with ex post charges not being able to be organized in a truly risk-based

way due to the fact that the insolvent insurance company, which may have been the

most at risk, is typically not charged at all, is extensively addressed by, for exam-

ple, Han, Lai, and Witt (1997, pp. 1119). The merits of prefunding and postfinancing

are discussed, for example, by Yasui (2001, p. 13): ex ante levies have the advantage

of enabling relatively quick handling of insolvency cases, as funds for policyholder

compensation are always available. This is especially important in dealing with the

bankruptcy of a larger insurer, for which a considerable amount of funds needs to

be mobilized within a short period of time. Furthermore, the existence of a sufficient

amount of funds for policyholder protection ensures the visibility of the safety net

and thus contributes to maintaining public confidence in the industry. However, the

ready-to-use funds may introduce moral hazard for consumers, companies, and su-

pervisors. In addition a lack of sufficient funds could, given its visibility, adversely

affect public confidence. Also, while prefunding allows better predictability for mem-

ber companies with regard to (foreseen) future financial burdens, postfinancing has

the advantage of incurring virtually no administration costs (such as fund manage-

ment costs) until an insolvency case arises: member companies can retain funds until

these funds are required. Rymaszewski, Schmeiser, and Wagner (Forthcoming) ex-

amine the conditions under which a self-supporting insurance guaranty fund may

be beneficial for policyholders. In their framework, the concept of utility-based pre-

miums is introduced and possible diversification benefits are measured through a

change in utility for risk-averse policyholder collectives.

Another set of contributions analyzes the existing guaranty scheme systems, looking

almost exclusively at the U.S. system. Recent work by Bernier and Mahfoudhi (2010)

discusses guaranty schemes from Canada and the United States in terms of the incen-

tives resulting from ex post levies. Feldhaus and Kazenski (1998) discuss model-based

alternatives, in particular bankruptcy prediction models and class rating, for U.S.

insurance guaranty schemes, focusing on a risk-based assessment as an alternative

to the “flat-rate” version where the assessment provides no penalties to insurers who

choose to engage in more risky operations. The determining factors identified include

the premium growth and concentration, level of loss reserves, retention, and finan-

cial leverage. Most closely aligned with our approach, Sommer (1996) examines the

impact of an insurer’s level of insolvency risk on the prices that the insurer obtains

5An exception from this rule is the German life insurance guaranty fund scheme, where charges

depend on company ranking according to their financial capacity, defined as equity relative

to solvency margin.