The Relationship Between Regulatory Pressure and Insurer Risk Taking

• DOI: http://doi.org/10.1111/j.1539-6975.2012.01505.x
• Author: Yi‐Hsun Lai,Wen‐Chang Lin,Michael R. Powers
• Published date: 01 June 2014
• Date: 01 June 2014

©

DOI: 10.1111/j.1539-6975.2012.01505.x

271

THE RELATIONSHIP BETWEEN REGULATORY PRESSURE

AND INSURER RISK TAKING

Wen-Chang Lin

Yi-H sun L ai

Michael R. Powers

ABSTRACT

The article examines the risk-taking behavior of property–liability insurers

in the presence of risk-based capital regulation. An option pricing model is

developed to evaluate the expected regulatory cost and predict a nonlinear

relationship between regulatory pressure and insurers’ risk taking. We then

conduct an empirical test using the simultaneous threshold regression. The

result shows that there is a threshold effect of regulatorypressure on insurer

risk taking. Poorly capitalized insurers seem to be aware of their proximity

to regulatory interventions but do not fully respond to the impending reg-

ulatory pressure. This implies either regulatory interventions are not costly

enough or they are too late, or both.

INTRODUCTION

Understanding the risk-taking behavior of financial institutions, including banks and

insurance firms, is important to not only regulators but also claimholders of these

firms because the behavior can substantially affect values of the firms and thus how

the values are distributed between claimholders. A number of theories have been

proposed to explain the behavior in the banking and insurance literature. However,

they often make contradictory predictions regarding the risk-taking behavior of fi-

nancial institutions. For example, the risk-subsidy hypothesis predicts that banks and

insurers will engage in excessive risk taking when deposit insurance for banks or

guarantee funds for insurers are nonrisk based. The reason is that the deficit of de-

posits and insurance policies will be absorbed by government funds when these firms

become insolvent, and thus the firms pay little cost for their high risk taking. When

banks/insurers attempt to increase their risk taking, they can either increase portfolio

risk or lower capital level, or both. Hence, the risk-subsidy hypothesis predicts a neg-

ative relationship between capital and risk. Another stem of theories regarding the

Wen-ChangLin is an associate professor in the Department of Finance, National Chung Cheng

University,Taiwan.Yi-Hsun Lai is an assistant professor in the Department of Finance, National

Yunlin University of Science and Technology, Taiwan. Michael R. Powers is a professor in

the Department of Finance, Tsinghua University, and on leave from the Department of Risk

Management and Insurance, Temple University. Wen-Chang Lin can be contacted via e-mail:

finwcl@ccu.edu.tw.

The Journal of Risk and Insurance, 2013, Vol. 81, No. 2, 271–301

272 THE JOURNAL OF RISK AND INSURANCE

risk-taking behavior of financial institutions, in contrast, advocates that these firms

will operate in a finite-risk paradigm if relatively large costs can result from high

risk taking. These costs include transaction costs,1agency costs,2bankruptcy costs,3

regulatory costs,4and others.5This class of theories anticipates that financial insti-

tutions will sustain their financial strength by either raising capital when their asset

risk is increasing or lowering asset risk when their capitalization is declining, and

thus predicts that capital and risk levels will be positively correlated. Despite the fact

that these two distinct types of theories have their relative merits, it seems unlikely

that the costs and the benefits resulting from risk taking are mutually exclusive. For

example, if a firm decides to adjust its risk to a lower level, the rationale behind the

change must be that the decrease in the associated costs as a whole is larger than the

decrease in the benefits resulting from government subsidy. The logic of this line of

reasoning leads us to conclude that banks and insurers choose their optimal mix of

capital and risk based upon a trade-off between the associated costs and benefits.

The property–liability (P–L) insurance industry has been characterized by high busi-

ness risk, intense competition, and relatively stringent regulation from governments.

However, in relation to the extensive research on the risk-taking behavior of banks,

there are a small number of studies investigating the risk-taking behavior of insurers.

Cummins and Sommer (1996) find that insurers are likely to restrain their risk taking

due to policyholders’ demand for safety when the protection of guarantee funds is

incomplete. However, Lee et al. (1997) find that the existence of state guarantee funds

generally encourages insurers to increase risk taking. Baranoff and Sager (2002, 2003)

find that capital level and asset risk of life insurers are positively correlated. They

therefore conclude that life insurers overall were operated in a finite-risk paradigm to

curb transaction costs. There have been, nevertheless, relatively few studies devoted

to understanding the extent to which capital regulation can influence insurers’ risk

taking. Tofill the gap, the objective of the study is to examine the association between

regulatory pressure and the risk-taking behavior for P–L insurers.

Similar to what is observed in the banking industry, the risk-based capital (RBC)6

standard adopted in 1994 forms the principal basis for the current solvency

1Transaction-cost economics (see, e.g., Williamson, 1988) posits that financial institutions will

limit their product risks to forestall paying high financing costs, as the cost of debt financing

will increase if they sell risky products.

2The agency theory contends that the separation of management and ownership can lead to

lower risk taking by managers as they do not share residual profits with owners.

3Bankruptcy costs are those such as the cost of liquidating the firm and the loss of franchise

value.

4Regulatory costs have received relatively considerable research attention in the banking lit-

erature (e.g., Shrieves and Dahl, 1992; Jacques and Nigro, 1997; Park, 1997; Ediz et al., 1998;

Aggarwal and Jacques, 2001; Rime, 2001).

5For example, Repullo (2004) contends that risk taking of banks may be associated with the

degree of market competition. When markets are overcompetitive or appear to be monopo-

listic, firms may increase their risk taking. In contrast, under a moderate competitive market,

firms may lower their risk taking to protect their franchise value.

6RBC regulation aims to prevent costly insolvencies by mandating insurers to hold a satis-

factory level of capital. The required capital is determined by a formula-based risk measure

encompassing asset risks, underwriting risks, credit risks, and miscellaneous risks.

REGULATORY PRESSURE AND INSURER RISK TAKING 273

regulation in the insurance industry. RBC regulation is mainly designed to target

problem (i.e., poorly capitalized) insurers and take necessary corrective actions when

RBC ratios of these insurers fall below the required standard. These disciplinary

interventions will affect insurers’ operation and incur high regulatory costs to the in-

surers.7When these regulatory costs exceed the benefits from risk taking, the insurers

would stop taking risky investments. This line of reasoning motivates us to contend

that there can exist a threshold at which insurers alter their risk taking in response to

the cost–benefit trade-off.

Our intention to examine whether risk taking and regulatory pressure arenonlinearly

correlated in the insurance industry is also motivated by two related studies in the

banking literature. Shrieves and Dahl (1992) document that the extent to which RBC

regulation can influence a bank’s risk taking depends on how far the bank’s capital

level is away from the RBC standard. Jacques and Nigro (1997) find that RBC reg-

ulation is effective in controlling banks’ risk taking and particularly that weak and

healthier banks react differently to RBC regulatory pressure, suggesting that the cap-

ital level and the magnitude of regulatory pressure need not correlate in a monotonic

(i.e., linear) manner. Although Shrieves and Dahl (1992) and Jacques and Nigro(1997)

both recognize the nonlinear influence of regulatory pressure on banks’ risk taking in

their studies, they deal with the issue by simply using a dummy variable to partition

banks into two groups depending on whether their capital ratios fall below the explicit

RBC standard. These two studies further find that the influence of RBC regulatory

pressure on the risk-taking behavior of the two bank groups appears asymmetric.

Extending the studies of Shrieves and Dahl (1992) and Jacques and Nigro (1997), we

argue that there is an implicit threshold of regulatory pressure at which an insurer

will change its risk taking and the threshold, if any exists, does not necessarily equate

to the explicit RBC standard.

The study thus proposes a new research scheme to address the nonlinear relationship

between regulatory pressure and risk taking for insurers. We first develop an option

pricing model to illustrate how regulatory pressure is related to insurers’ risk taking.

To the best of our knowledge, this makes our study the first to apply the option

pricing model to the insurance field in such a context. The theoretical model shows

that insurers will alter their risk taking at a regulatory-pressure threshold where

savings in the expected regulatory cost are equal to reductions in the put option value

expropriated from guarantee funds. The existence of such an implicit threshold in

fact predicts a nonlinear relationship between regulatory pressure and risk taking.

At the second stage of the study,we use a simultaneous threshold-regression model8

to examine whether insurers’ risk-taking behavior is nonlinear and to evaluate the

effectiveness of capital regulation in terms of whether the trigger point of the RBC

standard for disciplinary action is adequate and how costly the disciplinary action is

to insurers. Our study is also the first to apply simultaneous threshold regression to

this area of research. We believe that the threshold-regression model is best suited for

the purpose of the study.It can ascertain whether a threshold effect exists and provide

7Recently, Cheng and Weiss (2012) find that the ability of the RBC ratio in predicting insurer

insolvencies is not consistent over time.

8Threshold regression was originally developed by Hansen (1999) and simultaneous threshold

regression was recently developed by Caner and Hansen (2004).