wenyen hsu1 agency cost and bonus policy of participating policies wenyen hsu feng chia university...
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Wenyen Hsu 1
Agency Cost and Bonus Policy of Participating Policies
Wenyen Hsu
Feng Chia University
Email: [email protected]
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Table of Contents
The features of participating policies Literature Review Approach of the Paper Simulation Results Conclusions
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The Features of Participating Policies
Policyholders share the surplus accumulated by the insurer because of deviations of actual from assumed experience. Mortality rate Interest rate Expense ratio
The assumptions are relatively conservative.
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Policy value according rG
B(t)
P(t)Age
Face value
The Features of Participating Policies
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The Features of Participating Policies
In mathematic form,
rp(t) policyholder interest rate in t rG guaranteed interest rate B(t) policyholder reserve in t P(t) policyholder reserve in t γ target buffer ratio α distribution ratio
)})1(
)1((,max{)(
tP
tBrtr Gp
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The Features of Participating Policies
Therefore, the interest rate guarantee implies a floor of the credited rate.
The dividend mechanism is an option element of the contract.
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The Features of Participating Policies
Options embedded in a participating policy Bonus option Guaranteed rate Insolvency put option from insurer
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Questions
Questions Does the fact that policyholders share the
upside potential while insurers retain all the downside risk alter the investment incentives of insurers?
How these options interact with each other?
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Literature Review
Grosen and Jorgensen (2000) Propose a formula for credited interest rate and
argue the participating policies consist a risk free bond element and an option element
Assume insurer invests in risky assets and simulate the value of participating policies in terms of the policyholders under various combined of α, γ and asset risk.
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Literature Review
However, the paper assumes Only bond investment Value of a policy does not depend only on the
demand side, supply side’s behavior also matters.
Do not incorporate capital.
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Literature Review
Iwaki and Yumae (2004) Incorporate the supply side’s decision. Add capital in the model Find the efficient frontier for insurer
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Approach of the Paper
Want to improve theory by Introducing risk capital
Risk Adjusted Return on Capital (RAROC) Incentive effect of participating policies on
insurer’s investment decisions Participating levels Guaranteed rates Default risks
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RAROC
RAROC: Risk adjusted return on capital
CaR: Capital at Risk
RAROC focuses on the left tail.
CaR
emiumPrRiskRAROC
_
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Incentive Problems
The features of participating policies A combination of interest rate guarantee and an
option element The value of the option depends on the risk of
asset portfolio More volatile assets lead to higher value of the
option for policyholders and more capital for stockholders.
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Incentive Problems
Would the insurer increase the stock assets to enhance the value of option? May be not!
Most of returns would accrue to policyholders but stockholders bear the risk.
Such incentive problem becomes more severe as the share (α) of the return to policyholders increases.
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Incentive Problems
Since insurers share return with policyholders but retain all the downside risk. The payoff of the policies to insurers is asymmetric. Therefore, this paper uses the RAROC, instead of the Sharpe Index.
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Hypotheses
Holding probability of default constant, There exists an one-to-one relationship between
participating ratio and risk-return for policyholders.
Higher guaranteed rates lead to more aggressive investment policies.
Higher ex-ante default risks lead to more conservative investment policies.
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Simulation
Assumptions and constraints Insurers operate in a perfect financial markets Expense charges, lapses and mortality are
ignored. The insurer offers only a participating
policy, expiring at time T, T>0.
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Simulation
At time t=0, the policyholder pays a single premium for a 5-year, with minimum guaranteed benefit participating policy. The dividend is credited each year.
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Assets Liabilities
Risky Asset
Zero Coupon Bond
Policy Reserve
Bonus Reserve
)(tV
)(tA
)(tC
)(tP
)(tB
)(tV )(tV
Simulation
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Asset Side
Two assets a risky asset A(t) and a zero coupon bond C(t).
Asset allocation factor β, denotes the proportion of the initial zero coupon bond C(0), i.e. C(0) = βV(0).
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Asset Side
By Vasicek (1997) model, the dynamics of risk free interest rate rt follows the stochastic differential equation:
The portfolio of the risky asset A(t) is assumed to follow the stochastic process:
ttt dWdtrbadr ][
tA dZtdWdttA
tdA 21)([)(
)(
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Liability Side
The Liability Side of Balance Sheet policyholder interest rate in t
Value of policy in year t
)})1(
)1((,max{)(
tP
tBrtr Gp
1))(1( tpt PtrP
t
ipt irPP
10 ))(1(
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Simulation
)})0(
)0((,max{)1( P
Brr Gp
)0())1(1()1( PrP p
Valuation of Participating Policy – Grosen and Jørgensen (2000) Determine Simulate A(1) Calculate
Determine
)1()1()1( PAB
)})1(
)1((,max{)2( P
Brr Gp
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Efficient Frontiers with Various Participating Levels - Insurer
γ= 0, rG=0.04, P(0)=100, r(0)=4%, β= 0.49~0.99, ρ=-0.1, T=5, VaR=95%
0
5
10
15
20
25
30
35
40
45
0 10 20 30 40 50
α =0
α =0.25
α =0.5
α =0.75
α =1
VaR
$
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α β VaR(95) ROR
0 61% 38.042 86.55
0.25 64% 32.198 84.56
0.5 71% 23.797 73.60
0.75 73% 20.302 56.04
1 75% 18.636 37.76
Efficient Frontiers with Various Participating Levels - Insurer
γ= 0, rG=0.04, P(0)=100, r(0)=4%, β= 0.49~0.99, ρ=-0.1, T=5, VaR=95%
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Efficient Frontiers with Various Participating Levels - Policyholders
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0.5
0 5 10 15 20 25
α =0
α =0.25
α =0.5
α =0.75
α =1
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γ= 0, P(0)=100, r(0)=4%, β= 0.49~0.99, ρ=-0.1, T=5, VaR=95%
Efficient Frontiers with Different Guaranteed Rates
0
5
10
15
20
10 15 20 25 30
rg=4%
rg=3%
VaR
$
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Efficient Frontiers with Different Guaranteed Rates
αrG=4% rG=3%
β VaR(95) ROR% β VaR(95)
ROR%
0.75 73% 20.302 56.04 78% 17.889 66.31
γ= 0, P(0)=100, r(0)=4%, β= 0.49~0.99, ρ=-0.1, T=5, VaR=95%
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Efficient Frontiers with Different ex-ante Default Risks
0
5
10
15
20
10 15 20 25 30
5%
10%
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Efficient Frontiers with Different ex-ante Default Risks
α
Prob=0.05 Prob=0.10
β VaR(95) ROR% β VaR(90)
ROR%
0.75 73% 20.302 56.04 77% 14.961 77.97
γ= 0, rG=0.04, P(0)=100, r(0)=4%, β= 0.49~0.99, ρ=-0.1, T=5
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Conclusions
The frontier present the investment opportunity sets for insurers.
The risk premium decreases with higher α. Therefore, insurers are likely to become more c
onservative with higher α since the payoff of additional risk decreases.
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Conclusions
If the slope of frontier measures the risk premium, the risk premium decreases with higher α. Therefore, insurers are likely to become more conservative with higher α since the payoff of additional risk decreases.
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Conclusions
There exists an one-to-one relationship between participating ratio and risk-return for policyholders.
Higher guaranteed rates lead to more aggressive investment policies.
Higher ex-ante default risks lead to more conservative investment policies.
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Thank You for Listening!