On the regulator-insurer interaction in a structural model

In this paper we provide a new insight of the previous work of Grosen and Jørgensen [2002]. More precisely, firstly, we investigate the impact of regulatory authorities’ rules on the fair value of company’s liabilities and assets. We study how to choose regulation intervention levels in order to control the shortfall probability of the issuing company. The fact that the regulation rule depends on the assets’ volatility implies that “fixed volatility rule” becomes completely useless whenever the insurance company follows a dynamic investment strategy. Therefore, secondly, we study the interaction between the regulator who determines the regulation rule and the insurance company’s risk management. Following the recent work of Ballotta, Haberman and Wang [2005] and the guidelines of the IASB, we develop an analysis of the model error when the insurance company is informed of the regulation rules and trades according to a certain discrete risk management hedging strategy instead of staying passive until the contract’s maturity.