Insurance Guarantee Schemes Based on Analysis of Probability of Default Using Structural Approach Case Study: General Insurance

Abstract

This study examines the design of an insurance policy guarantee scheme by estimating insurers’ loss risk based on the probability of default using a structural approach and credit risk exposure in the Indonesian general insurance market. The analysis is conducted on a sample of publicly available financial data from general insurance companies in Indonesia over the period 2013 – 2022. Issues such as insurer default, bankruptcy, financial distress, and the absence of a formal policyholder protection scheme in Indonesia motivate this research. To the best of our knowledge, this study is the first to apply a structural credit risk approach to estimate default probabilities and credit exposure derived from technical reserves for the purpose of designing an insurance guarantee scheme in Indonesia. The probability of default is estimated using the Merton–KMV model, while claim reserves are calculated using the Bornhuetter–Ferguson method. The results indicate that both the level of default probability and the magnitude of claim reserves play a crucial role in determining the size of the ex-ante funding scheme. A decrease in default probability is observed when asset values increase, liabilities decline, and interest rates rise. While the KMV model relies on assumptions such as lognormal asset value dynamics and market efficiency, which may affect default probability estimates, the proposed funding reserve scheme remains sufficient to cover policyholder losses arising from insurer default and can be used to determine the contribution amount payable by insurance companies to the policy guarantee institution.