The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure
Schmeiser, Hato, Wagner, Joël, Journal of Risk and Insurance
The introduction of an insurance guaranty scheme can have significant in- fluence on the pricing and capital structures in a competitive market. The aim of this article is to study this effect on competitive equity-premium combinations while considering a framework with policyholders and equity holders where guaranty fund charges are volume-based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyhold- ers and equity holders are analyzed through a one-period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence, adverse incentives may arise with regard to the overall security level of the industry.
In many countries, insurance guaranty schemes are in place to cover a part of the obligations of insolvent insurers. Over recent decades, guaranty funds have been in- troduced when a country's insurance sector has assisted, in a cooperative effort with the regulator, in the liquidation of one (or more) defaulting companies. One example is German life insurer Mannheimer Lebensversicherung (344,000 life insurance con- tracts), which was in financial distress and then taken over in 2003 by a funded rescue company named Protektor. Today, Protektor acts as an insurance guaranty fund and a general rescue company for the German life insurance industry.1 Recent turbulence in the financial markets highlighted the need for a review of the current regulations. The latter include solvency measurement (e.g., European Union Solvency II), and the reexamination, or introduction where they do not exist, of customer guaranty sys- tems, as well as schemes for the banking and the insurance fields. While the review of banking deposit insurance systems in the European Union led to higher caps over the last year and months with homogenization by the end of 2011 (see, e.g., ECOFIN Council, 2008), the insurance sector has no comparable comprehensive system. It is undoubtedly difficult to justify the cost of insolvencies falling on taxpayers and so- ciety as a whole, even if adequate supervision can reduce the likelihood of insurers defaulting. A recent example, albeit in which the core insurance business may not have been the main trigger, is the bailout of insurance giant AIG in 2008, where it is still unclear whether taxpayers will ever be repaid in full.
As part of the European Union's response to the economic and financial crisis,2 the European Commission has announced a review of the adequacy of existing guaranty schemes in the insurance sector. The initiative, based on work undertaken since 2001, led to a White Paper in 2010, setting out a European solution for insurance guaranty schemes (European Commission, 2010b).3 Whereas in the United States each state has two guaranty associations, one for life insurance and the other for property-liability insurance, with both associations being incorporated in national organizations, the insurance guaranty scheme landscape in Europe is heterogeneous. An extensive anal- ysis of existing guaranty schemes in the European Union in 2007 (Oxera, 2007, p. 7) finds that 13 countries out of the 27 Member States had introduced relevant schemes supporting either the life or nonlife insurance sectors, or part of these.4 The guaranty scheme systems of the various countries are very similar, but differ in extent. From a (cross-border) European perspective, many questions arise when facing the challenge of unification, or of the fund volume needed (European Commission, 2010a). The lack of harmonized insurance guaranty scheme arrangements within the European Union hinders effective and equal consumer protection. In light of the lessons drawn from the recent crisis, the development of harmonized guaranty schemes could contribute to remedying the existing deficiencies, while not impeding the operation of the inter- nal insurance market by distorting cross-border competition. …