Default risk, bankruptcy procedures and the market value of life insurance liabilities

The topic of insolvency risk in connection with life insurance companies has recently attracted a great deal of attention. In this paper, the question is investigated of how the values of the equity and of the liability of a life insurance company are affected by the default risk and the choice of the relevant bankruptcy procedure. As an example, the US Bankruptcy Code with Chapter 7 and Chapter 11 bankruptcy procedures is used. Grosen and Jørgensen’s [Grosen, A., Jørgensen, P.L., 2002. Life insurance liabilities at market value: An analysis of insolvency risk, bonus policy, and regulatory intervention rules in a barrier option framework. J. Risk Insur. 69 (1), 63–91] contingent claim model, implying only a Chapter 7 bankruptcy procedure, is extended to allow for more general bankruptcy procedures such as Chapter 11. Thus, more realistically, default and liquidation are modelled as distinguishable events. This is realized by using so-called standard and cumulative Parisian barrier option frameworks. It is shown that these options have appealing interpretations in terms of the bankruptcy mechanism. Furthermore, a number of representative numerical analyses and comparative statics are performed in order to investigate the effects of different parameter changes on the values of the insurance company’s equity and liability, and hence on the value of the life insurance contract. To complete the analysis, the shortfall probabilities of the insurance company implied by the proposed models are computed and compared.