ABSTRACT
This paper develops a contingent claim framework to examine swap transactions between a life insurer and a bank that bilaterally price default risks. We show that the insurer (the protection buyer in the swap transaction market) regards the optimal bank loan rate as a strategic complement. In contrast, the bank (the protection seller) considers the optimal insurer guaranteed rate as a strategic substitute. Hedging conducted by the insurer enhances profits but hurts policyholder protection. Bank capital regulation harms policyholder protection. Insurer capital regulation leads to bank risk-taking. Capital regulations, as such, would jeopardize insurer-bank performance from a financial stability standpoint.
Acknowledgments
The authors would like to thank David Peel (editor) and an anonymous referee for their helpful comments and suggestions. The usual disclaimer applies.
Disclosure statement
The authors report no potential conflict of interest.
Notes
1 The swap transaction between the two parties also involves an intermediary who executes the transaction. For simplicity, the role played by the intermediary is ignored in our model.
2 Following Episcopos (Citation2008), we assume that there is a zero rebate on failure in EquationEq. (4)(4)
(4) .:
3 Episcopos (Citation2008) uses this formula to value a bank’s liability.: