Life Insurance and the Agency Conflict: An Analysis of Prudential Regulation to Guard Policyholders from Excessive Risk Taking

47 Pages Posted: 14 May 2010 Last revised: 24 May 2010

Date Written: May 24, 2010

Abstract

The paper builds on the current discussion on reforming insurance regulation in light of the EU's move towards the Solvency II regime and studies the agency problem in a life insurance environment. It compares different regulatory regimes in their effectiveness to control the owner's incentive for excessive risk taking, both in an analytically tractable life insurance model as well as in an application to a realistic market consistent valuation framework. As such it is the first paper to investigate the Solvency I & II regimes in an analytical framework and in the industry standard market-consistent embedded value (MCEV) methodology. By doing so, the paper fills the gap between qualitative assessments of Solvency II and the technical literature on life insurance valuation. The results suggest that the new Solvency regime eliminates an unfair subsidy of equity holders at the expense of policyholders in bad states of the world. Solvency II imposes an implicit restriction on asset performance through the link of capital requirements to asset performance and makes policyholder protection compatible with the shareholder incentive of equity value maximization. At the same time the continuous assessment of the default probability, as required by Solvency II, is shown to ensure that the regulator identifies changes in the risk position before insolvency looms.

Keywords: Solvency II, prudential regulation, agency conflict, market-consistent embedded value, life insurance valuation

JEL Classification: G13, G22, G33

Suggested Citation

Wiehenkamp, Christian, Life Insurance and the Agency Conflict: An Analysis of Prudential Regulation to Guard Policyholders from Excessive Risk Taking (May 24, 2010). Available at SSRN: https://ssrn.com/abstract=1605086 or http://dx.doi.org/10.2139/ssrn.1605086

Christian Wiehenkamp (Contact Author)

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