ARIA 2021 Annual Meeting

Arina Brutyan, Institute of Insurance Economics, University of St. Gallen; Hato Schmeiser, Institute of Insurance Economics, University of St. Gallen

Under the Solvency II regulation framework, European insurers are allowed to classify subordinated and hybrid debt with bail-in features as risk-based regulatory capital. In this paper, we aim to derive the optimal capital structure of insurance companies under the Solvency II regulation in the presence of subordinated debt and financial market frictions. Thereby, the valuation of the equity, subordinated debt and policyholders stakes is employed by the spread option pricing framework developed in Bjerksund & Stensland (2014). Taking into account the policyholder’s willingness to pay derived by assuming probabilistic insurance pricing by Wakker et al. (1997), we show that it is optimal for insurance companies to fully exploit their subordinated debt capacity. We confront these results with an empirical data set, illustrating that European insurers currently possess large unused capacities for subordinated and hybrid debt.