2015 WRIEC

The World Risk and Insurance Economics Congress (the “World Congress”) stimulates corporate awareness and interest in risk-related research and provides a forum — a joint conference once in every five years — for networking among academics and industry and government professionals worldwide. The World Congress is open to “all persons” who share an interest in promoting education and research in the broad areas of risk and insurance. Except for their interest in the conference, preferably in the form of presenting a paper, no criteria are established for participant qualifications. The Asia-Pacific Risk and Insurance Association (APRIA), the American Risk and Insurance Association (ARIA), European Group of Risk and Insurance Economists (EGRIE), and The Geneva Association jointly organize the meetings.

Session 1A: Risk Preferences

Moral Hazard and State Dependent Utility with Loss Reduction

We consider a state dependent utility model with binary states where moral hazard occurs in loss reduction. We find different results depending on the relative sizes of the marginal utilities between the loss state and the no loss state. (i) If the marginal utilities are equal between the two states, the optimal insurance involves full insurance up to a limit and
coinsurance above the limit, which corresponds to the case of the state independent utility. (ii) If the marginal utility in the loss state is greater than that in the no loss state, then the optimal insurance includes full insurance, and the moral hazard problem becomes less severe than under the case of the independent utility. (iii) If the marginal utility in the loss state is less than that in the no loss state, then the optimal insurance includes the deductible up to a limit and coinsurance above that limit, and the moral hazard problem becomes more severe. We extend the model into a two period setting, and apply it to the cases of a debt contract of a firm and a wage contract.

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To hedge or not to hedge? Evidence via almost stochastic dominance

Under the framework of almost stochastic dominance, we show that portfolio insurance strategies is not preferred for most investors. Several types of portfolio insurance strategies are examined, including stop-loss portfolio insurance, synthetic put portfolio insurance and the constant proportion portfolio insurance. We find that in general portfolio insurance strategies is dominated by a buy-and-hold strategy in terms of almost first- and second-degree stochastic dominance, especially for longer investment horizons. Furthermore, for robustness, we show that the purely buy-and-hold strategy is preferred to the strategy mixed with buy-and-hold and portfolio insurance strategies for most investors.

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The Probability Premium Approach to Comparative Risk Aversion

In the framework of expected utility, nth-degree risk aversion/loving is unequivocally characterized by the sign of the nth-order derivative of the utility function, but there exist different notions of one decision maker being nth-degree more risk averse than another. This paper first reformulates Pratt’s (1964) probability premium approach to comparative (2nd -degree)
risk aversion with a nonrandom starting wealth, and then shows that the reformulated probability premium approach can be easily extended to deal with random starting wealth and comparative nth-degree risk aversion. The paper shows that interpersonal comparisons of various versions of probability premia for nth-degree risk aversion are characterized by the (n/m)th-degree Ross more risk aversion of Liu and Meyer (2013), where n m 1. Besides the original Pratt setting,
the same comparative nth-degree risk aversion extends to probability premia derived from the risk apportionment setting of Eeckhoudt and Schlesinger (2006) and the comparative statics setting of Jindapon and Neilson (2007).

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Session 1B: Actuarial Science in Life Insurance

Lapse and Reentry in Variable Annuities

Section 1035 of the current US tax code allows policyholders to exchange their variable annuity policy for a similar product while maintaining tax-deferred status. When the variable annuity contains a long-term guarantee, this “lapse-and-reentry” strategy allows the policyholder to potentially increase the value of the embedded guarantee. We show that for a return of-premium death benefit guarantee this is frequently optimal, which has severe repercussions for pricing. We analyze various policy features that may help mitigate the incentive to lapse, and compare them regarding the insurer’s average expense payments and their post-tax utility to the policyholder. We find that a ratchet-type guarantee and a state-dependent fee structure best mitigate the lapse-and-reentry problem, outperforming the typical surrender schedule. Further, when
accounting for proper tax treatment, the policyholder prefers a variable annuity with either of these three policy features over a comparable stock investment.

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Pricing of Variable Annuities – Incorporation of the Stochastic Surrender Behavior of Policyholders

Variable annuities represent certain unit-linked life insurance products offering different types of protection commonly
referred to as guaranteed minimum benefits (GMXBs). They are designed for the increasing demand of the customers for
private pension provision. In this paper we analytically price variable annuities with guaranteed minimum repayments
at maturity and in case of the insured’s death. If the contract is prematurely surrendered, the policyholder is entitled to
the current value of the fund account reduced by the prevailing surrender fee. The financial market and the mortality
model are affine linear. For the surrender model a Cox process is deployed whose intensity is given by a deterministic
function (s-curve) with stochastic inputs from the financial market. Hence, the policyholders’ surrender behavior
depends on the performance of the financial market and is stochastic. The presented pricing scheme incorporates the
stochastic surrender behavior of the policyholders and is only based on suitable closed-form approximations.

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Risk Management of Policyholder Behavior in Equity-Linked Life Insurance

The financial guarantees embedded in variable annuity (VA) contracts expose insurers to a wide range of risks, lapse risk being one of them. When policyholders’ lapse behavior differs from the assumptions used to hedge VA contracts, the effectiveness of dynamic hedging strategies can be significantly impaired. By studying how the fee structure and surrender charges affect surrender incentives, we obtain new theoretical results on the optimal surrender region and use them to design a marketable contract that is never optimal to lapse.

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Session 1C: Corporate Governance

Are CEOs Rewarded for Luck? – Evidence from the US Property-Liability Insurance Industry

This study examines whether CEOs are rewarded for luck or skill in the US property-liability (P/L) insurance industry and investigates the sensitivity of pay for luck and pay for skill to governance. CEO salaries are significantly related only with performance by skill, whereas the effect of performance by luck is stronger on bonuses. Performance by luck, performance by skill, and performance by firm characteristics are positively and significantly related with total compensation. Performance by skill has a stronger impact on total compensation than performance by luck. The effect of governance is not clear in the US P/L insurance industry, while the effect of performance by skill is consistently more prominent than the effect of performance by luck. This suggests that a contracting view is more prevalent in the US P/L insurance industry than a skimming view.

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Organizational Structure, Corporate Governance, Loss Reserve Error and Actuaries Switching in the U.S. Property Casualty Insurance Industry

This paper aims to examine the U.S. property casualty insurer’s organizational structure, corporate governance and loss reserve error in relation to actuaries switching. The results show that stock insurers are more likely to switch their actuaries than mutual insurers. Insurers with high percentage of long-tail business are also more likely to switch
their actuaries. Large and weak financial condition insurers are less likely to switch their actuaries. We find that insurers with under-estimated (over-estimated) reserve error in the previous year are not significantly to switch their actuaries. In terms of corporate governance variables, the evidence shows that insurers with large board size are more
likely to switch their actuaries from internal actuary to Big 6 actuarial firms, whereas insurers with CEO/Chairperson duality are more likely to switch their actuaries from Big 6 actuarial firms to internal actuary. We next examine the impact of organizational structure, corporate governance and actuaries switching on reserve error. The evidence shows that insurers tend to have less reserve error after actuaries switching than before. Insurers with CEO/Chairperson duality and high percentage of insider directors on the board are positively related to reserve error post actuaries switching. In addition, stock insurers are more likely to have less reserve error after actuaries switching from internal actuary to Big 6 actuarial firms than stock insurers without actuaries switching. Insurers with CEO/Chairperson duality and large board size are positively and significantly related to reserve error when actuaries switching from Big 6 actuarial firms to internal actuary. We also find that insurers with actuaries switching from internal actuary to Big 6 actuaries are more likely to have less under-estimate reserve error than insurers without actuaries switching. Examination of the impact of the Sarbanes-Oxley Act (SOX) on reserve error indicates that insurers are more likely to switch actuaries after SOX. After SOX, insurers with actuaries switching are more likely to less under-estimated reserve error. The overall results show that organizational structure, corporate governance and some firm characteristics affect actuaries switching, while actuaries switching and corporate governance variables have impact on insurers’ reserve error.

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Do Financial Experts on the Board Matter? An Empirical Test From the United Kingdom’s Non- Life Insurance Industry

We examine the relation between board-level financial expertise and six measures of performance using panel data drawn from the United Kingdom’s (UK) non-life insurance industry. We find that collectively, financial experts have a beneficial influence on the performance outcomes of insurers. We also observe that board-level qualified accountants and actuaries are linked with superior performance in all six of our selected financial outcome measures. Professional insurance underwriters are associated with sound solvency levels (low leverage) and underwriting results, but not positive earnings-based measures. This suggests that underwriters may not be as adept at group-level earnings enhancement as accountants and actuaries. Additionally, we find that the introduction of IFRS 4 in 2004/5 did not have a significant impact on board composition and financial outcomes. Finally, we consider that our results could have commercial and/or policy implications.

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