Insurance Companies and Firm-Wide Risk: A Barrier Option Approach
Journal of Insurance Research and Practice, Vol. 19, pp. 62-70, 2004
Posted: 30 Mar 2005
This paper employs a contingent claims framework to explore the impact of firm-level risk on the cost of float and profitability of the insurance firm. The barrier option pricing methodology is used to derive the default risk, and incorporates the impact of regulatory solvency margin on enterprise-wide risk. The regulatory constraint imposes a structural barrier representing the level of liabilities guaranteed to policyholders. Based on the current evidence, the implications of the empirical findings are consistent with implicit risk levels considered by credit rating agencies. More specifically, it is statistically supported the inverse relationship between the default risk of an insurer and the return on equity capital. It is also found that the margins paid for originating insurance business are negatively correlated to the cost of float. Finally, the analysis reveals that the higher the insurer's default risk, the higher the net premiums-to-assets ratio would be; implying lower cessions made to reinsurance. Thus, the desire to conduct business above and beyond the solvency threshold usually spells this risk-taking behaviour, which supports the fact that insurance firms accumulate rather than allocate capital to liabilities.
Keywords: Insurance, Risk analysis, Option Pricing, Regulatory solvency margin
JEL Classification: G2, G22
Suggested Citation: Suggested Citation