The Relations Among Asset Risk, Product Risk, and Capital in the Life Insurance Industry

Abstract

This paper explores the relation between capital and risk in the life insurance industry in the period after the adoption of life risk-based capital (RBC) regulation. To examine this issue, we use a simultaneous-equation partial-adjustment model. Three equations express the interrelations among capital and two measures of risk: product risk and asset risk. The asset-risk measure used in this paper reflects credit or solvency risk as in RBC. Product risk assessment for life insurance products is rationalized by transaction-cost economics - contractual uncertainty.

A significant finding is that for life insurers the relation between capital and asset risk is positive. This agrees with prior studies for the property/casualty insurance industry and some banking studies. But the relation between capital and product risk is negative. This is consistent with the hypothesized impact of guarantee funds in other studies. The contrast between the positive relation of capital to asset risk and the negative relation of capital to product risk underscores the importance of distinguishing these two components of risk.

Keywords: Capital, Risk, Life and health insurance, Simultaneous equations, Transaction-cost economics

JEL Classification: C31, G32, G22, G28, K12