ICIR Working Paper Series No. 10/12
Edited by Helmut Gr¨undl and Manfred Wandt
Safety versus Aﬀordability as Targets of Insurance Regulation in an Opaque Market: A Welfare Approach
Rayna Stoyanova ^{∗} and Sebastian Schl¨utter
Abstract
Insurance regulation is typically aimed at policyholder protection. In particular, regulators attempt to ensure the ﬁnancial ’safety’ of insurance ﬁrms, for example, by means of capital regulation, and to enhance the ’aﬀordability’ of insuran ce, for example, by means of price ceilings. However, these goals are in conﬂict . Therefore, we identify situations in which regulators should be more concerned w ith ’safety’ or, alternatively, ’aﬀordability’. Our model incorporates defaultr isksensitive in surance demand, capitalrelated frictional costs, and imperfect ris k transparency for policyholders.
Keywords: Insurance Regulation, Regulatory Targets, Welfare, Opaqueness
^{∗} Corresponding author. Goethe University Frankfurt, Faculty of Econom ics and Business Admin istration, Department of Finance, International Center for Insurance Regulation, House of Finance, Grueneburgplatz 1, 60323 Frankfurt, phone: +49 69 798 33680, fax: +49 69 798 33691, email:
stoyanova@ﬁnance.unifrankfurt.de
1
Introduction
In attempting to meet their overall objective of protecting policyholder interests,
insurance regulators employ different techniques aimed at two subordinate objectives. First,
insurance
regulators
expend
significant
effort
to
ensure that
insurance companies
are
sufficiently solvent to meet policyholder claims. In this context, the future regulatory regime
Solvency II in the European Union, for example, contains riskbased capital requirements,
qualitative requirements regarding insurers’ risk management practices, and transparency and
disclosure standards for insurer risk profiles. ^{1} Second, regulators frequently employ measures
aimed at making insurance more affordable. For example, in some U.S. states, rate regulation
is in force for workers’ compensation, automobile, and medical malpractice insurance. Even
though the insurance markets in the European Union were deregulated in 1994, there is also
some degree of price regulation in the EU: in Germany, for example, private health insurers
are required to offer a basic tariff (Basistarif) whose premium is limited in accordance with
the maximum rate in the statutory health insurance.
At first sight, these two regulatory objectives—“safety” and “affordability”—appear to
be in conflict, and there is sparse theoretical work on how insurance regulators should act so
as to effectively protect policyholder interests. Empirically, Klein et al. (2002) demonstrate
that stringent price ceilings induce insurers to attain higher leverage ratios and thus reduce
their safety level. This finding is in line with the (not insurancespecific) theoretical argument
that firms use debt as a strategy to influence the regulator to increase the regulated price. ^{2} In
the context of insurance, there is another, simpler explanation for this observation: since the
regulated premium influences the insurers’ expected profits per insurance contract, it affects
^{1} A global overview of the introduction of riskbased capital standards is provided by Eling and Holzmüller
(2008).
^{2} See Taggart (1981), Spiegel and Spulber (1994), and Dasgupta and Nanda (1993).
2
their incentive for attracting customers with a strong financial position (Schlütter, 2011). A
significant price ceiling therefore is accompanied by relatively high insolvency risk. Vice
versa, there are theoretical arguments that stringent solvency regulation might increase
insurance premiums. First, solvency regulation affects the insurer’s default put option, which
is reflected by insurance premiums. ^{3} Second, to attain a higher safety level, insurers’ face
additional risk management costs, such as costs of reinsurance or frictional costs of equity
capital (cf. Froot, 2007), that may be passed on to the consumer in higher insurance
premiums.
This article investigates how regulatory requirements designed to meet the objectives of
“safety” and “affordability” influence an insurer’s optimal capital and pricing strategy, and
how these decisions affect policyholder welfare. Based on these results, we investigate in
which situations regulators should focus either more on “safety” or, alternatively, on
“affordability”. Throughout our analysis, we employ a model with an inhomogeneous group
of policyholders whose preferences are represented by an insurance demand function,
depending on the insurance premium and the insurer’s safety level. ^{4} The insurer decides on its
shareholdervaluemaximizing equitypremium combination by anticipating the consequences
for insurance demand.
Insurer
safety level
is
not
necessarily perfectly transparent
to
policyholders and the insurer’s equity endowment may be subject to frictional costs, such as
corporate taxes.
In a benchmark case, we first derive the insurer’s optimal strategy in the absence of
regulation. We determine the insurer’s optimal safety level by balancing its incentives
resulting from demand reaction against the default put option and the frictional costs of
equity. Next, we analyze the influence of riskbased capital requirements. Here, the regulator
^{3} See, e.g., Doherty and Garven (1986), Gründl and Schmeiser (2002), and Gatzert and Schmeiser (2008).
^{4} Our model design is similar to the setups of Cummins and Danzon (1997), Zanjani (2002), Froot (2007), Yow and Sherris (2008), and Schlütter (2011).
3
can specify the insurer’s safety level, to which the insurer reacts by adjusting the insurance
premium. We find that the regulator cannot enhance welfare by means of solvency regulation
as
long
as
policyholders
are
perfectly informed
about
default
risk.5
However,
when
policyholders cannot perfectly monitor the insurer’s safety level, capital regulation can
enhance consumer welfare, even though it causes an increase of insurance premiums. Based
on numerical examples, we demonstrate that the effectiveness of capital regulation increases
with the degree of opaqueness, with the level of capitalrelated frictional costs and with the
severity of underwriting risks. Finally, we study the consequences of regulatory price ceilings.
We demonstrate that the net effect of enhancing the affordability of insurance, on the one
hand, and reducing the insurer’s optimal safety level, on the other hand, can be either positive
or negative for policyholder welfare. Our numerical examples indicate that price ceilings will
be effective when the market is transparent and when frictional costs are low. Thus, markets
in which price ceilings are effective have characteristics contrary to markets in which capital
regulation is appropriate.
The remainder of the article is organized as follows. Section 2 presents the model
framework and introduces the objective functions. Section 3 derives the insurer’s optimal
strategy in the benchmark case without regulation. Section 4 studies the effectiveness of
solvency regulation. Section 5 explores the consequences of price ceilings. Section 6
concludes.
^{5} This result is in line with the model of Rees et al. (1999).
4
2
Model Design
2.1 Actors and Timing
Our oneperiod model is based on models proposed by Zanjani (2002) and Schlütter
(2011). We consider an opaque insurance market with a homogeneous product and three
stakeholder groups: insurance buyers, an insurer, and a regulator.
Insurance Buyers
The insurance buyers are offered an insurance product at a certain price and default risk.
Their buying decisions are a reaction to these characteristics. Cumulative consumer reaction
is modeled by an aggregate demand function, which depicts the representative preferences of
an inhomogeneous group of insurance buyers and sums to the number of customers for whom
purchase of the offered insurance product is advantageous.
We utilize a twoparametric demand function , where denotes the unit price of
the insurance product and is the default ratio that the insurer communicates to consumers.
We define the default ratio as the ratio of the arbitragefree value of unpaid claims to the
value of nominal liabilities, that is, liabilities without default risk. The default ration is used in
the model as a measure of risk. To keep the model tractable, we apply a specific form of the
demand function:
_{} _{A} BCDEF ^{}^{} ^{}^{}^{} ^{} ^{A} ,
5
(1)
where D is a scale parameter and _{} and _{} _{A} are the sensitivity factors with respect to price and
default ratio. ^{6} The demand function has the following properties: ^{}^{}^{}^{}^{}^{} ^{A} ^{}^{} ^{B} C _{} E
A _{}_{} A
C _{} _{A} E , that is, policyholders react negatively to increases in price and
default risk. This exponential form of an insurance demand function was recently derived by
Zimmer et al. (2011) from an experiment in which the participants were confronted with
insurance contracts subject to default risk. The experimental results show participants’
willingness to pay for a household insurance contract with a certain default risk level. The
demand function is imperfectly elastic with regard to price and default risk, that is, because of
switching and information costs, small changes in price and default ratio do not reduce the
demand to zero. ^{7}
Insurer
The second party in the model, the limited liability insurer, maximizes its shareholder
value ( ) and makes decisions as to its risk management strategy and underwriting activity
in the presence of regulatory constraints, that is, it decides on its default ratio and
insurance price .
The insurer’s objective function is the present arbitragefree market value of the endof
period equity capital _{!} minus the initial equity endowment ",
C _{!} "
(2)
# is the arbitragefree valuation function. Equity funds are used as a risk management tool
to ensure the realized solvency level. Owing to corporate taxation, agency costs, and
^{6} The sensitivity parameters _{} and _{} _{A} depict only the aggregate preferences of consumers and do not account for any opaqueness effects in the market. ^{7} See D’Arcy and Doherty (1990), Cummins and Danzon (1997), Zanjani(2002), and Yow and Sherris (2008).
6
acquisition expenses, equity endowment is assumed to imply upfront frictional costs, which
are modeled by a proportional charge $ % . ^{8} Considering the insurer’s limited liability, the
final payoffs to shareholders at time 1 are given by the future value of the available assets & _{!}
minus the nominal claims ' _{!} plus any unpaid losses above the available assets, that is, the
shareholders’ default put option ()* _{!} C +,./' _{!} & _{!} 0 1. To develop asset and liability
values over time, we assume a geometric Brownian motion process. At time 0, the arbitrage
free value of the final shareholder payoffs is then
_{2} C& _{2} ' _{2} 3 ()* _{!} . The insurer’s
initial assets are denoted by & _{2} C E 3 4 $ E ". Furthermore, 5 C ' _{2} 6 denotes the
6
arbitragefree initial value of the nominal liabilities per contract, C ()* _{2} ' _{2}
denotes the
6
default ratio, and 7 C & _{2} ' _{2}
denotes the initial assetliability ratio. Using the option pricing
formula, the default ratio can be determined as follows: ^{9}
7 8 C 9 : 7 E 9 : 8
8 C ;8 _{<} ^{=} 38 _{>} ^{=} ?@8 _{<} 8 _{>}
:
C AB. C
D
3 ^{!}
= ^{8}
(2)
where 9 is the distribution function of the standard normal distribution, 8 _{<} and 8 _{>} are the
volatilities of the assets and liabilities, respectively, and @ is the correlation between them.
Since 7 8 is a continuous and strictly decreasing function in 7 8 , there is a unique
inverse function 7 8 .
Appling the above relationships, we represent the shareholder value function as follows:
^{8} This is a common approach in the literature; see Zanjani (2002), Froot (2007), Yow and Sherris (2008), and Ibragimov et al. (2010). ^{9} For explanation, see, e.g. Myers and Read (2001), p. 553.
7
C
C E E 5 E 4 F $"
C
E G 5 E 4 _{!} _{} _{H} 5 E 7 8 I
H
(3)
(4)
Therefore, the insurer’s decision problem is to find the optimal and legally allowable
combination of default risk level and insurance price that maximizes its shareholder
value.
Regulator
The regulator uses two instruments to achieve its “safety” and “affordability” targets. It
has the option of introducing solvency regulation, in the sense of capital requirements, as a
way of improving the safety of insurance companies. The second tool is price restriction,
which is used to make insurance products more affordable by setting a maximum allowed
price.
The regulator’s
objective function
is
consumer surplus
maximization, which
is
calculated as the sum of the differences between the reservation price, that is, the maximum
price a consumer would pay for the insurance product, and the offered price over all
policyholders:
L
J C _{K}
(5)
To study the effectiveness of the two regulatory tools and be able to compare them, we
bring in an effectiveness variable that measures the percentage change of consumer surplus,
defined as the absolute change in consumer surplus divided by the consumer surplus in an
unregulated market, ^{M}^{N} ^{} ^{O}^{P}
MN
QRQS OP
_{M}_{N} _{Q}_{R}_{Q}_{S} _{} _{O}_{P}
. Additionally, we look at the percentage change of
8
shareholder
value,
shareholder value.
^{N}^{T}^{U} ^{} ^{O}^{P} _{} _{N}_{T}_{U} QRQS OP
_{N}_{T}_{U} _{Q}_{R}_{Q}_{S} _{} _{O}_{P}
,
to
2.2 Modeling Opaqueness
study the
regulatory
impact
on
the
insurer’s
Market opaqueness is formalized by introducing a deviation parameter V, V W E 0 4F,
which measures the divergence between promised default ratio and realized default ratio. We
distinguish between the default ratio. _{} _{A} , which the insurer promises and communicates to
the consumers, and the default ratio _{A}_{X}_{Y}_{Z} , which it realizes after the contract has been
signed. In a perfectly transparent market, the deviation parameter equals zero: V C .
Furthermore, if the insurer can deviate from its promise, that is, V [ , it always does so to
the fullest extent possible and realizes the highest possible default ratio because this raises its
shareholder value. ^{1}^{0} Therefore, we introduce the following relations between the realized and
promised default risk:
_{} _{A}
C _{A}_{X}_{Y}_{Z} 4 V
\ C AXYZ A C AXYZ V
Consumer Surplus in an Opaque Market
(6)
As mentioned, consumer surplus measures the cumulative utility for policyholders of
buying the insurance product. However, in the case of an opaque market, different aspects of
the calculation must be considered.
Calculation of consumer surplus in both a transparent and an opaque market is illustrated
in Figure 1. Assume that the insurer realizes the default ratio _{A}_{X}_{Y}_{Z} . The dashed line in Figure
^{1}^{0} For a detailed explanation, see Section 3.
9
1 shows for how many consumers it is advantageous to buy insurance. Given that the insurer
decides on the premium ^{]} _{A}_{X}_{Y}_{Z} , the dark shaded area below the dashed curve gives the
consumer surplus in the transparent market. In an opaque market, the promised default ratio
_{} _{A} deviates from the realized one. The solid curve in Figure 1 represents the number of
consumers who actually purchase insurance observing the default ratio _{} _{A} . Since the actual
default ratio is higher than _{} _{A} , consumers overestimate the utility they will derive from
insurance, and there are some consumers whose utility is reduced by purchasing insurance.
The black area in Figure 1 measures the loss of consumer surplus resulting from this effect.
Under the premium ^{]} _{A}_{X}_{Y}_{Z} , the consumer surplus in an opaque market is the dark grey
area minus the black area. Formally, consumer surplus is calculated as:
L
J _{A}_{X}_{Y}_{Z} V C _{K} ^
^{]}
` AXYZ
^{]}
a E ^{]} d E _{} _{A} ^{]} ` _{K}
^
d
YAb.cAY .YAXY
eZYfb.YAXY
AXYZ
a F
Here, d is defined by _{A}_{X}_{Y}_{Z} d C _{} _{A} ^{]} .
(7)
Figure 1: Insurance demand function and welfare loss in a nontransparent market
10
3
Optimal Solutions in an Unregulated Market
As a benchmark case and comparison basis for the different regulatory approaches, we
consider an unregulated insurance market in which the insurer can decide on its SHV
maximizing equitypremium combination without regulatory constraints. Here, the insurer’s
maximization problem is:
ghi _{}_{} _{A} _{}_{}_{} . _{A}_{X}_{Y}_{Z} . C
C
_{A}_{X}_{Y}_{Z} E 4 V E G 5 E 4 _{A}_{X}_{Y}_{Z} _{!} _{} _{H} 5 E 7 _{A}_{X}_{Y}_{Z} 8 I
H
(8)
In an opaque market, the insurer’s realized safety level will deviate from the level
promised: the insurer can increase demand by communicating a lower default risk level than it
actually ensures. The actual default risk level corresponds to a lower equity endowment and
therefore incurs fewer frictional costs.
Based on the firstorder condition of Equation (8), we can determine the insurer’s
optimal premium for a given default ratio _{A}_{X}_{Y}_{Z} :
^{]} _{A}_{X}_{Y}_{Z} C hjkghi _{} _{A}_{X}_{Y}_{Z}
5 E 4 _{A}_{X}_{Y}_{Z} a 3 $ E 5 E 7 _{A}_{X}_{Y}_{Z} 8 5 E 4 _{A}_{X}_{Y}_{Z} B 3
`
^
`
Transfer of frictional cost of equity
a
C ^
Arb. free value of lBmnopBqr.qAplsm
!
_{.}
t
Profit spou nv
(9)
The optimal price is calculated as the sum of the arbitragefree value of claim payments,
plus frictional costs transferred to policyholders, plus a profit loading. Note that the
transparency level influences the insurer’s optimal default risk level, but has no direct effect
11
on the premium: the optimal premium ^{]} _{A}_{X}_{Y}_{Z} depends only on the insurer’s actual default
risk level, not on the promised level.
Let
_{A}_{X}_{Y}_{Z} C hjkghi _{} _{A} ^{]} . denote the insurer’s
]
SHVmaximizing
(actual) default ratio. Solving the insurer’s maximization problem (Equation (8)), the first
]
order condition for the optimal choice of _{A}_{X}_{Y}_{Z} ^{]} , given that the price is optimally
adjusted, implies that
_{}_{} ! w
^{E}
! x ^{C}^{y} ^{} xz
!
x
!
E {C A _{} _{O}_{}_{}} D
{
A
.
(10)
The lefthand side of Equation (10) represents the marginal change of insurer’s benefits due to
demand reaction when the default ratio is marginally changed. The right hand side measures
the marginal change of default put option and frictional costs of equity. Rewriting Equation
(10) enables us to present the insurer’s SHVmaximizing assetliability ratio 7 ^{]} using a
closedform solution: ^{1}^{1}
7 ^{]} C~ _{H}_{Ä} 4 V ^{!} ^{} ^{H} Å.
H
with ÇEiF C ÉiÑ Ö Ü E á ^{} ^{!} Ö ^{!} _{à} â
ä
^{ã}
=
(11)
â and á ^{} ^{!} denoting the quantile function of the standard
normal distribution. One can easily verify that ÇEiF is a strictly increasing function in x.
Therefore, the insurer will optimally avoid default risk by holding a high capital level if, c.p.,
demand reacts strongly to default risk, weakly to price, frictional costs are low and the
insurance market is rather transparent than opaque.
^{1}^{1} The derivation is analogous to Schlütter (2011), Proposition 2.
12
We then have the following equations for the maximal shareholder value and resulting
consumer surplus in the unregulated market:
_{A}_{X}_{Y}_{Z} E 4 V ^{]} C ^{}^{}^{} ^{A} ^{} ^{O}^{}^{}}
]
]
E ! w ^{]} B
_{} ! H
.
J _{A}_{X}_{Y}_{Z} E 4 V ^{]} C ^{}^{}^{} ^{A} ^{} ^{O}^{}^{}}
]
]
E ! w ^{]} B ! _{}_{} A _{} _{O}_{}_{}} wB
]
.
(12)
(13)
These equations illustrate that shareholders benefit from a greater degree of opaqueness,
whereas consumers suffer: in Equation (13), 4 _{} _{A} _{A}_{X}_{Y}_{Z} V represents the consumer
surplus loss resulting from market opacity. In the numerical examples, we measure the
consequences of opaqueness for safety level, insurance premium, shareholder value, and
consumer surplus in an unregulated market.
Numerical Example
Throughout
our
analysis,
we
illustrate
our
results
with
a
realistically
calibrated
numerical example. We set the following risk parameters: 5 C ? , 8 _{<} C åç, 8 _{>} C? ç,
and @ C , ^{1}^{2} éèêëè. êgÑíêÉì. 8 C _{î}_{å}_{ç} ^{=} 3? ç ^{=} ï #? ñ?#. We further assume a frictional
cost
ratio
of. $ C åç. ^{1}^{3}
For. simplicity,
parameters are as follows: ^{1}^{4}
we
set.
C ç#. The
demandfunctionrelated
^{1}^{2} These numerical assumptions are consistent with the marketbased calibrated model of Yow and Sherris
(2008).
^{1}^{3} Zanjani (2002) reports that the frictional costs for the reinsurance industry can be approximated with 5%.
^{1}^{4} These parameters are consistent with the regression results estimated by Zimmer et. al (2011).
13
Demandfunctionrelated parameters
ó 
ò 
0.015 
ó 
ô 
14 
ö 
10 000 
Table 1: Demandfunctionrelated parameters
In our benchmark scenario, the numerical input variables result in the following optimal
combination of price and default risk, shareholder value, and consumer surplus for the three
transparency levels / 0 #õ0 #ñ1:
Opaqueness level 
A 
B 
C 

úCù 
úCù#û 
úCù#ü 

ò ^{]} ô† ^{]} 
_{2}_{7}_{1}_{.}_{8}_{1} 
269.99 
268.95 

^{ô}^{†} 
] 
0.1606% 
0.2632% 
0.7036% 

†°¢£ 

ô† 
ò† 
0.1606% 
0.1842% 
0.2814% 

^{§} ] ^{]} ^{} ^{ô}^{†} †°¢£ 
6 485.90 
4 583.44 
623.557 

• 
165.79 
167.21 
170.15 

¶ß® 
_{1}_{1} 
_{6}_{3}_{4}_{.}_{1}_{1} 
11 734.05 
11 940.16 

©¶ 
11 
052.41 
11 024.11 
10 672.67 
Table 2: Numerical results in an unregulated market for three transparency levels
Table 2 compares the perfectly transparent case V C with two levels of opaqueness,
V C #õ and V C #ñ. Interestingly, both the promised and the actual default risk level clearly
increase with level of opaqueness. Therefore, according to Equation (9), the premium
decreases
with
opaqueness
level.
Regarding
insurance
demand
reaction,
the
premium
reduction overcompensates the higher (promised) default risk in the opaque market and,
therefore, more insurance contracts are sold. While this increases shareholder value, the
higher actual default risk level reduces consumer surplus. The resulting combinations of
consumer surplus and shareholder value are illustrated in Figure 2.
14
Figure 2: CS and SHV for insurer’s optimal combination of default risk and price under no regulation for three
transparency levels
4 Effectiveness of Capital Regulation
We next analyze the situation in which the regulator restricts the insurer’s risk level by
means of riskbased capital requirements, but prices remain unregulated. This situation is
more or less the actual regulatory environment in the European Union ever since insurance
markets were deregulated in 1994. ^{1}^{5}
In our model, the regulator implements riskbased capital requirements by restricting the
insurer’s (actual) default ratio at a level ^{A}^{X}^{c} , forcing the insurer to hold a sufficient level of
capital. The restriction is binding when the regulatory default ratio ^{A}^{X}^{c} falls below the
]
shareholdervaluemaximizing level _{A}_{X}_{Y}_{Z} . For the opaque market, we assume that the
insurer can still communicate a better default risk level than ^{A}^{X}^{c} .
Facing capital requirements, the insurer adjusts the premium so as to maximize
shareholder value (see Equation (9)):
^{1}^{5} According the Swiss Solvency Test, a confidence level of 99% for the calculation of the risk measure tailVaR was stipulated. Solvency II regulations are even more stringent and define a confidence level of 99.5% for the calculation of the used risk measure VaR.
15
^{]} ^{A}^{X}^{c} C hjkghi _{} ^{A}^{X}^{c} .
.C
5 ^ E 4 ` ^{A}^{X}^{c} a 3 $ E 5 E 7 ^{A}^{X}^{c} 8 5 E 4 ^{A}^{X}^{c} B 3
Arb. free value of lBmnopBqr.qAplsm
^
`
a
Transfer of frictional cost of equity
!
t
Profit spou nv
(14)
Equation (14) demonstrates that the optimal insurance premium is negatively related to
the regulatory default ratio ^{A}^{X}^{c} . First, a lower value of ^{A}^{X}^{c} means that the insurer’s
default put option decreases and thus the first premium component increases. Second, the
insurer needs to hold additional equity capital to achieve a lower default ratio and the related
frictional costs are transferred to policyholders with the second premium component. Thus,
stricter capital requirements will lead to a higher premium. When deciding on the welfare
optimal policy of capital requirements, the regulator needs to balance their positive influence
on the safety level against their negative influence on affordability. Formally, the consumer
surplus in dependence of ^{A}^{X}^{c} and V is given by:
J _{A}_{X}_{Y}_{Z} VBC ^{} ^{Ö} ^{} ^{A} ^{} ^{O}^{}^{}}
AXc
OP
E ! w ^{]} A _{} _{O}_{}_{}} Bâ ! _{}_{} A _{} _{O}_{}_{}} wB
OP
OP
Taking the firstorder derivative of J _{A}_{X}_{Y}_{Z} VB with respect to _{A}_{X}_{Y}_{Z}
AXc
AXc
(15)
enables us to
determine how strict the capital requirements should be. We have
_{} _{A} J V C
.
™ ^{]} 4 _{} _{A} _{A}_{X}_{Y}_{Z} V 4 $ ^{} ^{}^{}
^{E}
!
w
!
H
35 ^{H}^{Ä}
!
H
E C # A
Å
^{}
VÅC
(16)
Analogous to Equation (10), we can rewrite Equation 16 as
16
^{}
E 4 V
!
! _{} Aw ^{} ^{E} ! x ^{C}^{y} ^{} xz
w
E {C A _{} _{O}_{}_{}} D
!
x
{
A
and analogous to Equation (11) we arrive at
_{7} AXc ] _{C}_{~} _{}
_{H}_{Ä} 4 V ^{!} ^{} ^{H} 3
H
w _{} HÄ ! _{} _{} _{A}_{w} _{} ^{Å}^{,}
_{}
, 
(17) 
(18) 
Even though Equation (18) is not generally a closedform representation of 7 ^{A}^{X}^{c} ^{} ^{]} (since the
righthand side depends on ), it can be interpreted by comparing it with Equation (11). If
V C , both equations coincide. In a perfectly transparent market, therefore, the insurer will,
based on its own incentives, decide on the consumersurplusmaximizing safety level.
Consequently,
capital
regulation
is
unnecessary
in
this
case.
However,
if
V [ ,
the
consumersurplusmaximizing safety level is higher than the SHVmaximizing one, and the
regulator should impose binding capital requirements to enhance policyholders’ welfare.
Numerical Example and Graphical Representation
We now apply the numerical example from Section 3 to the situation with capital
requirements. Table 3 contains the consumersurplusmaximizing regulatory default ratios,
the insurer’s optimal response, and the corresponding welfare levels. The first column of
Table 3 (V C ) illustrates, as discussed above, that the regulator cannot improve policyholder
welfare by capital regulation when the market is perfectly transparent: the consumersurplus
maximizing default ratio is equal to the insurer’s optimal strategy in the absence of regulation
(see Table 1). In the second (V C #õ) and third columns (V C #ñ), the regulator restricts the
default ratio below the shareholdervaluemaximizing default ratio of 0.1606%. Since the
premium is only affected by the realized default ratio (see Equation (14)), the insurance
17
premium is optimally adjusted for all three transparency levels. However, the insurer exploits
the opaqueness to promise higher safety levels and therefore insurance demand increases at
higher levels of opaqueness. Compared to our benchmark case with no regulation, optimal
capital requirements are stricter when there is opaqueness and, hence, such requirements can
increase consumer surplus by 0.25% for V C #õ and by 3.54% for V C #ñ.
Opaqueness level 
A’ 
B’ 
C’ 

úCù 
úCù#û 
úCù#ü 

^{ô}^{†} †°´ ] †°¢£ 
0.1606% 
0.1602% 
0.1589% 

ô† ò† 
0.1606% 
0.1121% 
0.0635% 

^{]} ^{} ^{ô}^{†} †°´ †°¢£ 
^{]} 
B 
271.81 
271.814 
271.826 

^{ò} 

• 
_{1}_{6}_{5}_{.}_{7}_{9} 
166.91 
168.01 

¶ß® ^{†}^{°}^{´} 
11 
634.11 
11 712.65 
11 790.47 

\¶ß® _{¶}_{ß}_{®} ö¨ö †°´ 
0.00% 
0.19% 
1.2% 

_{©}_{¶} †°´ 
11 
052.41 
11 052.15 
11 051.40 

\©¶ _{©}_{¶} ö¨ö †°´ 
0.00% 
+0.25% 
+3.54% 
Table 3: Numerical results under capital regulation for three transparency levels
Figure 3 is a graphic illustration of how capital regulation impacts shareholder value and
consumer surplus. Starting at Point A, the straight line illustrates that a binding regulatory
ceiling on the default ratio decreases shareholder value as well as consumer surplus. For an
opaque market with V C #õ, the thick curve starting at Point B demonstrates that moderate
capital regulation can improve consumer surplus up to Point B’, which refers to optimal
capital regulation (see Table 3). The dashed curve starting at Point C shows that capital
regulation in a heavily opaque market V C #ñ has a bigger influence on shareholder and
policyholder welfare and that the optimal regulatory policy (Point C’) greatly enhances
consumer surplus.
18
Figure 3: Combination of shareholder value and consumer surplus under capital regulation for three transparency
levels: fine line—ú C ù, thick curve—ú C ù# û, dashed curve—ú C ù# ü
5 Effectiveness of Price Regulation
Next, we investigate the consequences of regulatory price ceilings imposed with the
intent of meeting the regulator’s affordability target. The price ceiling will be binding when it
lies below the insurer’s unregulated premium (see Equation (9)). When only prices are subject
to regulation, and there are no capital requirements, the insurer can react to the mandatory
prices by adjusting its safety level.
Therefore, any regulatory price induces a specific insurer’s optimal default ratio
]
^{}^{} AXYZ
]
^{}^{} AXYZ
^{A}^{X}^{c} . The insurer’s maximization problem can be formalized as:
^{A}^{X}^{c} C hjkghi _{} _{A} _{A}_{X}_{Y}_{Z} V ^{A}^{X}^{c} ,
(19)
where ^{A}^{X}^{c} denotes the regulated premium. The optimality condition for the choice of a
default ratio level, that is, the firstorder derivative of the shareholder value with respect to
default ratio when the price is externally determined implies:
19
_{Æ} NTU
A
O} Ø _{} OP
C A _{} _{O}_{}_{}} w ^{} ^{O}^{P}
^{}^{} ^{A} O}
H
_{}_{} ^{A}^{X}^{c} 5 4 _{A}_{X}_{Y}_{Z} _{!} _{} _{H} 57 # ^{A}^{X}^{c} _{±}_{3} 5
5
H
C #
! H A
O} C
(20)
The first term is negative and measures demand effects for marginal changes in the default
ratio. The second term is positive and represents the value of the limited liability change. The
third term reflects marginal changes in the frictional costs of equity when the default ratio
varies. The level of opaqueness V has an influence on all three terms because it manipulates
the demand itself ( .
By using price regulation to improve insurance affordability, the regulator aims at
creating maximum consumer surplus. Equation (21) gives the regulator’s maximization
problem
^{A}^{X}^{c} C hjkghi J ^{A}^{X}^{c} _{A}_{X}_{Y}_{Z} ^{A}^{X}^{c} _{B}_{.}
]
_{} OP
C hjkghi _{} OP _{K}
L
_{} OP
]
AXYZ
^{A}^{X}^{c} d E _{} _{A} ^{A}^{X}^{c}
^{(}^{2}^{1}^{)}
To study the effect of price restrictions on consumer surplus and to determine the
optimal price ceiling we look at the firstorder derivative of the consumer surplus with respect
to price,
MN
^{}
_{O}_{P} . In the optimum, we obtain
^{]} 4 _{} V 4 V B
_{}_{} AXc
4 _{} V
_{C} _{}_{} _{}
20
(22)
The lefthand side of the equation measures the negative effect to which policyholders
are exposed because of the lower safety level resulting from the lower prices. The righthand
side represents policyholders’ additional gain through price decrease. Therefore, as soon as
the welfare gain of lower prices outweighs the loss due to the decreased safety level, the
change
in
consumer
surplus
is
positive
and
the
regulatory
intervention
leads
to
an
improvement in policyholder welfare. Maximum consumer surplus is attained when the
equation holds. Further price reduction results in higher losses due to worse default risk.
Numerical Example and Graphical Representation
Once again, we illustrate our analytical findings using the numerical example introduced
in Section 3. The regulator decides on the consumersurplusmaximizing price ceiling, ^{A}^{X}^{c} ^{} ^{]} .
The insurer adjusts its realized default risk, _{A}_{X}_{Y}_{Z} ^{A}^{X}^{c} ^{} ^{]} under the objective shareholder
]
valuemaximization. The resulting shareholder value and consumer surplus are set out in
Table 4. The effectiveness of price regulation is measured by the percentage change in
consumer surplus.
When the regulator introduces a price ceiling, we observe an improvement in consumer
surplus in all three cases. For V C , the regulator should optimally reduce the premium from
271.81 in the benchmark case (see Table 2) to 222.35 (Table 4). The insurer subsequently
increases the default ratio from 0.16% to 1.18%, meaning that the DPO per contract increases
by 200*(1.18%0.16%)=2.04. From the policyholder perspective, the premium reduction of
49.46 overcompensates for the DPO increase of 2.04, and therefore the consumer surplus
clearly increases by more than 80%.
In an opaque market (V C #õ), the insurer adjusts its default ratio to the price ceiling
more strongly, because policyholders have a weaker influence on the insurance safety level.
21
The regulator should
therefore restrict
the premium
relatively moderately by 269.99
229.63=40.36. Nevertheless, the DPO increases even more strongly compared to the first case
by
200*(1.37%0.26%)=2.22.
From
the
policyholder
perspective,
price
restriction
still
dominates the unregulated situation, however the effectiveness of price regulation is lower in
opaque markets: for the highly opaque case V C #ñ, the consumer surplus change is only
18%.
Opaqueness level 
A’’ 
B’’ 
C’’ 

úCù 
úCù#û 
úCù#ü 

_{ò} 
†°´ ] 
222.35 
229.63 
247.60 

^{ô}^{†} ] †°¢£ 
_{} _{ò} †°´ ] _{} 
1.1847% 
1.3733% 
1.7241% 

ô† ò† 
1.1847% 
0.9611% 
0.6896% 

• 
301.61 
279.12 
221.73 

¶ß® ^{†}^{°}^{´} 
6906.94 
8655.42 
11282.85 

\¶ß® _{¶}_{ß}_{®} ö¨ö †°´ 
40.6% 
26.24% 
5.50% 

_{©}_{¶} †°´ 
20107.60 
17529.27 
12641.00 

\©¶ 
_{©}_{¶} ö¨ö †°´ 
+81.93% 
+59.01% 
+18.44% 
Table 4: Numerical results under price regulation for three transparency levels
The resulting combinations of regulatory price and corresponding shareholdervalue
optimal default ratio lead to specific combinations of shareholder value and consumer surplus,
represented by the bent curves in Figure 4. Every curve represents a different transparency
level. The dashed curve is for when V C #ñ, the thick curve for when V C #õ and the fine
curve represents a fully transparent market. Points A’’, B’’ and C’’ represent the consumer
surplus optimal positions.
22
Figure 4: Combination of shareholder value and consumer surplus under price regulation for three transparency
levels: fine line—ú C ù, thick curve—ú C ù# û, dashed curve—ú C ù# ü
6 Comparison of capital and price regulation
The previous analysis has shown that capital and price regulation could be beneficial for
policyholders. In this section, we compare the effectiveness of the two regulatory tools and
explore what kind of regulation is most appropriate to improve consumer surplus under
different circumstances.
Impact of frictional costs
In the following subsection, we analyze the effectiveness of capital and price regulation
depending on the level of frictional costs. As before, we consider three levels of opaqueness
V C / 0 #õ0 #ñ1 and plot the maximum achievable percentage change of consumer surplus
AXc
when the regulator chooses the consumersurplusmaximizing _{A}_{X}_{Y}_{Z} ^{} ^{]} and ^{A}^{X}^{c} ^{} ^{]} respectively.
Figure 5 illustrates the case of perfect transparency. The solid line depicts the potential
consumer surplus increase with price regulation and the dashed line the effectiveness of
capital regulation. In the transparent market, policyholders force the insurer to choose a
23
default risk level that also maximizes consumer surplus. Therefore, irrespective of the level of
frictional costs, capital regulation cannot raise consumer surplus and the dashed curve
remains at 0%. Price regulation, in turn, can significantly enhance consumer surplus, but its
effectiveness decreases with the level of frictional costs. The reason for the decreasing
effectiveness of price regulation is that the insurer will respond with a more drastic reduction
of its safety level when equity capital is subject to high frictional costs.
Figure 5: Effectiveness of price and capital regulation in a perfectly transparent market when the carrying charge of
holding capital changes
In a slightly opaque market V C #õ, our analysis provides similar results (see Figure 6).
Here, the consumersurplusmaximizing default risk level differs only very slightly from the
shareholdervaluemaximizing level, and therefore capital requirements have little influence
on the consumer surplus. Again, price regulation may increase consumer surplus and the
effectiveness of price regulation decreases with the level of frictional costs.
24
Figure 6: Effectiveness of price and capital regulation with opaqueness level of 0.3 when the carrying charge of
holding capital changes
The case of the high level of opaqueness is illustrated in Figure 7. Here, capital
requirements can clearly raise consumer surplus, particularly when frictional costs are high.
Furthermore, the effectiveness of price regulation is lower and more affected by frictional
costs than in the previous scenarios. If the carrying charge is above 11%, capital regulation is
more effective than price regulation. Therefore, regulators should optimally focus on the
safety goal if insurance markets are rather opaque and frictional costs are extreme. Empirical
studies suggest that the opaqueness problem is severe in insurance markets therefore
providing support for this scenario. ^{1}^{6}
^{1}^{6} Morgan (2002) and Pottier and Sommer (2006) empirically estimate opaqueness for different industries. Using the rating disagreement as a proxy for opaqueness, the studies find that insurance and banking are most severely affected by the opaqueness problem.
25
Figure 7: Effectiveness of price and capital regulation with opaqueness level of 0.6 when the carrying charge of
holding capital changes
Impact of volatility of liabilities
Next, we examine the effectiveness of capital and price regulation for insurance
portfolios of varying volatility. Again, we look at the three levels of opaqueness, V W
/ 0 #õ0 #ñ1. The results are plotted in Figures 8 to 10.
As before, capital regulation cannot improve policyholder welfare in a fully transparent
market (see Figure 8), which is the case regardless of the portfolio volatility. Price ceilings
strongly increase consumer surplus when the insurance risks are low, and they have a smaller
effect when the insurance portfolio is highly volatile. The reason behind this finding is that
the insurer needs to hold much more equity capital for the highrisk portfolio and the price
ceiling clearly reduces the incentive to hold a large amount of equity. Therefore, the insurer
with high insurance risks responds to a price ceiling with a severe reduction of its safety level,
leading to a smaller increase of the consumer surplus as compared to the lowrisk insurer.
26
Figure 8: Effectiveness of price and capital regulation in a transparent market when the volatility of liabilities changes
Figure 9 illustrates the regulatory effectiveness for different volatility levels in a slightly
opaque market, where we have similar results as for V C . Interestingly, capital regulation
still cannot enhance consumers’ welfare for all meaningful values of the riskiness of
insurance claims, since the insurer’s SHVmaximizing safety level is almost identical to the
consumersurplusmaximizing one.
Figure 9: Effectiveness of price and capital regulation with opaqueness level of 0.3 when the volatility of liabilities
changes
27
Figure 10 depicts the considered effects for the highest opaqueness level, V C #ñ. Now,
the dashed line has a clearly positive slope, meaning that capital regulation is effective,
especially when insurers have a highrisk portfolio. The solid line has a clearly negative slope,
and the effectiveness of price ceilings thus decreases with the volatility of insurance risks.
When the volatility of the liabilities exceeds 35%, capital regulation becomes more effective
than price regulation.
Figure 10: Effectiveness of price and capital regulation with opaqueness level of 0.6 when the volatility of liabilities
changes
7
Conclusion
This article investigates how regulatory capital requirements and price ceilings influence
an insurer’s capital level and pricing decisions and what consequences arise for policyholders’
welfare. To this end, we employ a model in which insurance demand is sensitive to default
risk and price, policyholders’ view of the insurer’s safety level may be opaque and the insurer
faces frictional costs of holding equity capital. The insurer’s objective is the shareholder
value, which we measure using the present value of shareholders’ future cash flows minus
their initial equity endowment. Policyholders’ welfare is measured using the consumer
28
surplus, i.e. the integral over the differences between their willingnesstopay and the actual
insurance premium.
To evaluate the consequences of regulatory intervention, we consider the insurer’s
strategy in a world with no regulation as a benchmark case. Here, the insurer balances its
incentives for safety (resulting from insurance demand reaction) against the frictional costs of
holding equity capital. The insurer also exploits the policyholders’ opaqueness problem and
promises a higher safety level than that which it actually ensures. According to the safety
level decision, the insurer also determines the SHVmaximizing insurance premium.
By means of riskbased capital requirements, the regulator can force the insurer to attain
a higher safety level. The insurer will react to this type of regulation by adjusting its premium.
We show that capital requirements cannot enhance policyholders’ welfare when the insurance
market is transparent, since the insurer finds it optimal to attain the exact safety level that
maximizes consumer surplus. If the regulator requires a higher safety level, premiums become
too high such that policyholders are worse off. In contrast, capital requirements can improve
policyholders’ welfare in the more realistic case of there being an opaqueness problem. ^{1}^{7} Our
numerical examples indicate that capital requirements are especially effective when the
market is highly opaque, when equity capital comes at significant frictional costs, and when
insurers face significant underwriting risks. In these cases, the regulator should concentrate on
the safety goal.
If the regulator imposes a binding price ceiling, the insurer has weaker incentives to
attract consumers with a high safety level, and it will reduce its equity position. Nevertheless,
we point out that price ceilings can be beneficial for policyholders, especially when insurance
buyers’ reaction drives default risk down and frictional costs of equity capital are rather low.
^{1}^{7} Cf. Morgan (2002) and Pottier and Sommer (2006).
29
Altogether, our findings suggest that regulators should take both targets, safety and
affordability, into account under the overall objective of policyholder protection. While our
findings on price ceilings do not overrule typical concerns about antitrust measures, they do
shed light on the insurancespecific interaction between price regulation and safety. Our
sensitivity analyses indicate in which situations insurance regulators should focus their efforts
on solvency regulation in particular, or monitor profit loadings on premiums and create the
basis for antitrust regulation.
30
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