國
立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
Chapter 1 Introduction
This thesis aims to investigate two important issues for long term investors, i.e., solving the optimal asset allocation allowing international investment and evaluating the cost of bankruptcy considering regulatory forbearance.
According to portfolio choice theory in Solnik (1974) and Grauer and Hakansson (1987), economists have long been conscious of the advantage of global diversification. However, the role of the exchange rate affection is not well evaluated in literatures. The empirical results on long-term predictability of exchange rates are a well-documented phenomenon (see, e.g., Mark (1995), Allen and Taylor (1992), and Kilian and Taylor (2003)). Therefore, the learning effect of exchange rate prediction is incorporated to solving the international asset allocation in chapter 2.
The bankruptcy announced by Lehman brother which cause the global financial crisis of 2008. The major center bank around the world cut the interest rate in the coordinate move and its lead the global economy into an unprecedented low interest environment. Negative interest rate has been an urgent situation in Taiwanese life insurance industry and become worse due to the action from the major center bank.
Several Taiwan life insurance company are facing large assets depreciation and insolvency problem accord to the risk-based capital (RBC) requirement. To relieve the domestic life insurer solvency capital pressure, the Financial Supervisory Commission (FSC) relaxed the RBC requirements to slow down the fall in insurer RBC resulting from the depression in the domestic stock market. However, Kuo Hua Life Insurance had been took control by the FSC on August 5 2009. As the end of December 2009, Kuo Hao had a negative net worth of NT$62.1 billion, with assets valued at NT$256 billion and 2 million policyholders. Due to the large loss in the life insurance industry,
‧
solvency and capital adequacy problems is critical for existing life insurers and for potential new entrants to the market. When the company faces the insolvent problem, the regulator might adopt the action of regulatory forbearance to delay its bankruptcy, which means a regulator reduce the scope of regulation or withdraw entirely from regulating specified markets. Hence, in the study two questions are explored when the regulator adopting the regulatory forbearance approach. There are “How to define a quantitative index of regulatory forbearance to evaluate the different government intervention criteria” which is discussed in chapter 3, and “How to examine the cost of insurance guaranty fund incorporating the regulatory forbearance” is illustrated in chapter 4.
Chapter 2, entitled “Exchange Rate Predictability in International Portfolio Selection”, provides theoretical findings and the numerical illustrations of exchange rate predictability in the international portfolio choice problem. Uncertainty regarding the predictive relation affects the optimal portfolio selection through dynamic learning, and creates a state-dependent relation between the optimal asset allocation and the investment time horizon. This study investigates the investment behaviors of constant relative risk adverse (CRRA) investors and adjusts the exchange rate process by the observed interest rate dynamics. This approach is implemented through a filtering mechanism to evaluate the learning effects in the portfolio selection problem that were not fully explored by Lioui and Poncet (2003). Since the learning process updates the market price of exchange rate risk, this approach makes the necessary modifications based on exchange rate predictability. This study presents numerical illustrations showing that the learning mechanism significantly increases the terminal wealth, and investigates the effect of learning on the asset mix. We find that:
1. The optimal portfolio selection can be depicted through the four-fund theorem introduced by Rudolf and Ziemba (2004). The four funds are the international
‧
myopic portfolio, the domestic interest rate hedge portfolio, the cross-country interest rate differential hedge portfolio, and the domestic riskless asset. The proportions of each fund invested in the individual assets depend only on the asset return characteristics and not on investor preferences; and the investor’s optimal demands for the three funds depend on his preferences.
2. The learning effect enhances the terminal wealth performance for strategic investors. However, the improvement ratio decreases with declining the mean return of the exchange rate.
Chapter 3, entitled “Too Big to Fail or Too Small to Save: Regulatory Forbearance and Guarantee Benefits in Taiwan Life Insurance Market”, provides illustration of the definition of regulatory forbearance in academic. The global financial crisis in 2008 resulted in systematic risks in the equity, asset, and credit markets that created significant deprecation in the life insurer’s balance sheet. To maintain prudent supervision and market stability, supervisory bodies announced a temporary risk-based capital relief plan. Hence, maintaining solvency standard became a critical issue to avoid moral hazard for the market players and potential entrants, forcing them to be competent based on a prudent regulation framework.
Following Grosen and Jogensen (2002) and Chen and Suchanecki (2007), this study explicitly calculates the guarantee benefits based on the financial leverage of the insurer and plausible regulatory forbearance through a Parisian barrier option.
This study compares relative and absolute intervention criteria by measuring theirs effect on the guarantees benefits. Results show that the relative intervention criterion is more sensitive to financial leverage than the absolute intervention criterion is. Thus, increasing the leverage ratio of the insurer increases the guarantee benefit per asset. Conversely, extending the relief plan and reducing the intervention standard decreases guarantee benefit per asset. These effects decrease if the forbearance
‧
duration or the minimal intervention standards exceed certain levels. We show that:
1. The guarantee benefit index can capture the two features about regulatory forbearance. As the change of grace period and the change of the ratio of monitoring, the guarantee benefit index reflects the variation sensitivity.
2. Comparing different intervention criteria, relative intervention criterion results a uniform force of regulatory with respect to different firm sizes. If the grace period is longer enough, the average force of regulatory of two different intervention criteria will converge to a steady state.
Chapter 4, entitled “An Analysis of the Bankruptcy Cost of Insurance Guaranty Fund under Regulatory Forbearance”, provides an analytical treatment for the cost of guaranty fund. This study investigates the bankruptcy cost when a financially distressed life insurer is taken over by the supervision authority. Specifically, this study adopts the framework proposed in Grosen and Jogensen (2002) and Chen and Suchanecki (2007) to measure the implied default cost of the Taiwan insurance guaranty fund (TIGF) during the financial restructuring. The compensation of the guaranty fund is calculated incorporating the grace periods caused by the regulatory forbearance, which is similar to Chapter 11 bankruptcy procedures in the US Code.
This study adds to the previous works of Cummins (1988) and Duan and Yu (2005) by explicitly defining the embedded default options and incorporating the grace period induced by the regulatory forbearance. The main results are:
1. Beside some special condition, the leverage ratio, asset volatility, and the ratio of monitoring have the parallel effect to the cost of guaranty fund. Asset volatility is the most important factor affected the bankruptcy cost while the financial ratio and intervention criterion have shown relatively minor influence.
2. The current premium rates (i.e., 20 basis points for non-life insurers and 10 basis points for life insurers) for the Taiwan insurance guaranty fund are not risk
‧
國立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
sensitive and hence the financial restructuring should be designed to ease the moral hazard problem.
The above three essays study two research topic about portfolio selection and bankruptcy. In current life insurance industry, cross-country investment is conversant with insurance company. We exploit the learning mechanism to improve the terminal wealth which has significant effect. After global financial crisis, the life insurance industry had suffered asset value shirked by the fluctuated capital market. How to reduce the bankruptcy cost through early regulatory intervention becomes an important public issue. We construct a quantitative index of regulatory forbearance called the guarantee benefit index to evaluate the force of regulatory and price the cost of guaranty fund.
This thesis proceeds as follows: Chapter 2 investigates international asset allocation incorporating the exchange rate prediction. Chapter 3 evaluates a benchmark index of regulatory forbearance and uses this index to compare different intervention criteria. The cost of guaranty fund is priced under regulatory in Chapter 4.
‧
國立 政 治 大 學