Three essays on the effects of risk and regulation on the price of term life insurance
While life insurers are generally free to set prices on term life insurance contracts, they face three constraints in doing so. Two of these constraints, insurance premium taxes and insurance guaranty funds, are imposed by state governments, while the third, the insolvency risk premium of insurance contracts issued by a specific insurer, is imposed directly by the market. The first two essays estimate the effects of the two government-imposed constraints on the price of term life insurance. In essay one, we look at how guaranty funds affect the price of term life insurance. Guaranty funds, which exist in every state, reduce the cost of insurer insolvency to policyholders by paying out death benefits up to a specified amount, usually $300,000, on policies written by insurers that have become insolvent. We show theoretically, using an expected value model, and empirically, using data from the California term life insurance market, that the price per thousand dollars of coverage is significantly lower for policies with a face value above the amount guaranteed by the state guaranty fund. In essay two, we estimate the effects of state insurance premium taxes on the price of term life insurance. In estimating the effects of state-specific premium taxes on the price of term life insurance, we linearly bifurcate each state's premium tax into a domestic premium tax, which is paid by all life insurance companies, regardless of domicile, and a retaliatory tax, which is paid only by an insurer whose state of domicile has a premium tax greater than that of the state in which the policy is written. We find that a one percent increase in both the domestic premium tax and the retaliatory tax increase the price of term life insurance by less than one percent. Finally, in the third essay, we estimate the effect of an insurer's insolvency risk, as measured by A.M. Best Financial Strength Ratings, on the price of a term life insurance contract issued by that insurer. Insurance contracts sold by an insurer with a relatively lower rating should sell at a discount to policies written by firms with a higher rating. We find strong evidence that insurers with a relatively higher A.M. Best rating actually charge lower prices.