Paper available here.
Authors: William Perraudin and Siyi Zhou
This study has devised and implemented for a sample of UK non-life assurers a risk management model that allows one to calculate the failure probabilities of the firms in question alone or in combination with a bank.
The model generalises the ratings based credit risk model widely employed by firms and regulators to assess banking book credit risk and to parameterise capital requirements for the new Basel Accord.
Extending this model to include insurance lines permits one to assess the failure probabilities implicit in current levels of insurer economic and regulatory capital and to examine the implications for risk of mergers between banks and insurers.
Our analysis shows that mergers may have sound economic justification through the economies they permit in economic capital. Bank and insurer combinations can achieve the same confidence level with much less capital than the institutions are currently holding collectively.
There may, of course, be other economic motives for mergers such as economies of scale in the distribution of retail financial products but these are beyond the scope of this research.
We also show that the default probabilities implicit in prevalent levels of non-life insurer economic capital are very low except for two cases where the firms involved were subsidiaries of larger entities.