The Risk Of Insurance Companies, External Supervision And Capital Structure Decision

This paper investigated the relations between optimal capital structure of insurers and its internal risk characteristics, together with outside regulations. As insurance markets are highly regulated, the level of capital held by insurers is determined not only by the risk factors such as costs of financial distress, agency costs and asymmetric information, but also by the regulatory regime. Based on the theoretical and empirical analysis, some suggestions on optimizing the capital level of the insurer were given from the perspectives of regulators and insurers.Since insurers operate on liabilities, they hold certain level of capital to cover the financial losses caused by unexpected risks. Unfortunately, capital is costly due to such frictional costs as regulatory costs, transaction costs and taxes, etc. Therefore, insurers would not hold enough capital to absorb all risks. How much capital should be reasonable for an insurer to hold? Market may encourage insurers to hold certain capital to maximize its market values in the absence of regulation. This paper discussed the optimal level of capital held by the insurer in the face of all risks coupled with external regulations based on modern capital structure theory and option pricing theory.In a mature market, the level and structure of capital held by the insurer is determined jointly by both the market and the regulations. In China market, a market far from being mature, how should the level of capital held by the insurer be determined? Or in other words, what are the dominant factors ? This paper also analyzed the level of capital held by Chinese insurers from positive perspective. This paper did a thorough research on the movement trends and their drivers of the capital level held by Chinese insurer from 1995 to 2005. Then, OLS was further used to analyze the impact of risk characteristics and solvency regulation on the capital structure.In a rather long period into the future, Chinese insurers will continue to face the risk of capital shortage. How can they optimize their capital structure, shield from insolvency risk and enhance competitiveness? Based on the above theoretic and positive analysis, this paper proposed suggestions on optimizing the capital structure of the insurer were given from the perspectives of regulators and insurers. Regulators are advised to choose the right capital regulatory model appropriate to the current market condition, enhancing the sensitivity of the capital model to risk. In the mean time, regulators are advised to design incentive mechanism to allow insurers to build their internal model to embody their individual risk nature, which will be used to calculate their own optimal level of capital. The insurers are advised to strengthen their capital structure. In the short term they might attempt to add more capital; in the medium term, to build economic capital model embodying their own risk factors; in the long term to adopt total risk management strategy to optimize their capital structure with diversified risk management tools. Driven by the risk sensitive capital regulation, insurers will build more appropriate and effective risk management system to shun insolvency risks.