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Sunflower
Sunflower management and life management
insurance: modeling the CEO’s and life
insurance
utility function
Jyh-Horng Lin 309
Department of International Business,
Received 26 May 2018
Tamkang University, New Taipei City, Taiwan Revised 19 September 2018
Fu-Wei Huang Accepted 19 September 2018

Department of Management Sciences,

Tamkang University, New Taipei City, Taiwan, and
Shi Chen
School of Economics,
Southwestern University of Finance and Economics, Chengdu, China

Abstract
Purpose – The purpose of this paper is to develop a theoretical framework to answer the following question:
What are the consequences of sunflower behavior as well as spread behavior for how asset-liability
management is administrated in a life insurance company?
Design/methodology/approach – This paper takes into account the following: the chief executive officer
(CEO) of a life insurance company confirms the board of directors’ belief – the preference of the like of higher
return relative to the dislike of higher risk; the authors call such behavior sunflower management; the life
insurance policyholder is entitled to a guaranteed interest rate and a participation percentage of the
company’s investment surplus; and the authors examine the optimal insurer interest margin, i.e., the spread
between the loan rate and the guaranteed rate.
Findings – Sunflower management translates into lower utility for the CEO and makes the CEO more
prudent to risk-taking at an increased insurer interest margin for the provision of life insurance contracts.
The effect of the guaranteed rate on the margin is ambiguous and depends on the level of guarantee itself.
An increase in the participation level decreases the CEO’s loan risk-taking at an increased margin. It is shown
that a trend toward higher return like of the board’s belief produces a corresponding trend toward the CEO’s
decreasing risk-taking when the return like is revealed strongly. The results indicate that sunflower
management as such is an important determinant in ensuring a safe insurance system.
Originality/value – This is the first paper to construct a contingent claim model to evaluate the expected
value of the CEO’s utility function defined in terms of the equity returns and the equity risks of a life
insurance company. The model explicitly considers CEO sunflower behavior, CEO spread behavior and the
limited liability of shareholders.
Keywords Guaranteed interest rate, Insurer interest margin, Participating life insurance contract,
Sunflower management
Paper type Research paper

1. Introduction
In the last decade, life insurance markets all over the world have grown rapidly. Under the
circumstances, the asset-liability management (ALM) of life insurance companies has
become more important as insurance business risks turn increasingly greater. A
fundamental scope of ALM of a life insurance company is the responsible administration
of the invested assets profitably (asset management) and sufficient obligations against
life insurance policyholders (liability management). In the ALM, the need arises for life
insurance companies to move from accountancy based on book values to a market-based Review of Behavioral Finance
value accountancy standard as required by Solvency II and the International Financial Vol. 11 No. 3, 2019
pp. 309-323
Reporting Standard (e.g. Jørgensen, 2004; Gerstner et al., 2008). This regulatory requirement © Emerald Publishing Limited
1940-5979
becomes much more crucial, in particular, when investment is core to the provision of DOI 10.1108/RBF-05-2018-0053
RBF insurance contracts for life insurance companies (Insurance Europe, 2014). Considerable
11,3 research effort has been put toward modeling such ALM to evaluate the equity and
liabilities of a life insurance company[1]. Academic studies in this area indicate that the
effectiveness of ALM is largely dependent on an understanding of the behavioral
characteristics of the life insurance company.
There are two insurer behavior issues, however, where a thorough understanding of
310 ALM is essential. First, it is an alternative approach that a model framework for the ALM of
life insurance contracts should consider the separation situation of management from
ownership where the life insurance company’s chief executive officer (CEO) has incentives
to make decisions, maximizing his/her own expected utility. This can be motivated based on
a delegation argument in the spirit of Jensen and Meckling (1976). In particular, taking the
delegation consequence of decision making under incentive conflicts seriously, Boot et al.
(2005) propose sunflower behavior in management: CEOs looks up at their board of
directors, trying to figure out what they are thinking, so that their actions match the
expectations and beliefs of the board. Why do CEOs behave like this? Recent corporate
governance theories suggest that greater board diligence leads to shorter CEO tenures and
produces a corresponding trend toward more frequent external hires as CEOs (Hermalin,
2005). Accordingly, CEOs may behave like a sunflower, turning toward the sun and seeking
nourishment for their survival. Second, an interesting issue we argue is that the underlying
assumption of perfectly competitive asset markets is rather not fulfilled in the balance-sheet
activities of life insurance companies. This perfectly competitive assumption is not
applicable to loan markets faced by life insurance companies since such markets are always
highly concentrated where life insurance companies set rates and face random loan levels[2].
Taking the loan rate-setting decision-making behavior becomes a key issue that concerns
insurer managers in the ALM. In particular, the insurer interest margin, i.e., the spread
between the loan rate set by the company and the life insurance policy’s guaranteed rate, is
one of the principal elements of efficient insurer liquidity management. Shim (2017) argues
that insurers’ profits primarily depend on the performance of both investment and
underwriting activities. Indeed, insurer investment strategies are primarily determined by
the duration, and the predictability of life insurance liabilities, and the appetite for risk.
Liquidity is central not only in strategic decisions made by life insurance companies but also
in decisions made by the regulators concerned about insurance stability.
The present paper fills this gap by asking the following question. What are the
consequences of such sunflower behavior as well as spread behavior for how ALM is
administrated in a life insurance company? This paper develops a theoretical framework
to answer this question. This is the first paper to construct a contingent claim model to
evaluate the expected value of the CEO’s utility function defined in terms of the equity
returns and the equity risks of a life insurance company. The model explicitly considers
CEO sunflower behavior, CEO spread behavior, and the limited liability of shareholders.
We also focus on a profit-sharing life insurance policy that the policyholder is provided
by the guaranteed rate of interest plus some surplus on the policyholder’s account
every period[3].
It is essential to investigate the relationships among guaranteed interest rate,
participation level, revealed preference, and the optimal insurer interest margin under
sunflower management. First, we can verify whether the relationship between life insurance
policyholder protection and insurer interest margin is complementary or substitutionary in
the ALM. The verification is important since investment returns linked with insurer spread
behavior are treated as an integral part of the life insurance policy itself. Second, in the
sunflower management model, the CEO maximizes his/her own expected utility, defined in
terms of the market value of the life insurance company’s equity, the instantaneous
standard deviation of the equity, and the default risk in the company’s equity return.
This utility setting allows us to realize the CEO’s preference effect on the spread behavior, Sunflower
and hence leads to making the life insurance company prudent or prone to risk-taking. management
Several results are derived. First, the optimal insurer interest margin is lower when the and life
objective is the equity maximization than when the objective is the CEO utility
maximization under sunflower management. Sunflower behavior as such makes the CEO insurance
more prudent to risk-taking for the provision of life insurance policies at the cost of a
reduced equity value. Second, for low guaranteed rate levels, the effect of the guarantee on 311
the optimal insurer interest margin is negative. For high guaranteed rate levels, the effect is
positive. The CEO faces a margin dilemma. Policyholder protection may be at the cost of the
CEO’s risk-taking, in particular, when the guaranteed rate is low. Third, we show that
the effect of the participation level on the optimal margin is positive. This result indicates
that the policyholder benefits from a better payoff distribution of the life insurance contract
as well as the CEO’s prudential investment for insurance policy provision. Finally, the CEO
also faces a risk-taking dilemma. When the board’s belief is a higher revealed preference of
the like of higher return relative to the dislike of higher risk, an increase in the preference
decreases the CEO’s risk-taking at an increased margin. When the board’s belief is a low
preference, an increase in the preference increases the CEO’s risk-taking at a reduced
margin. In conclusion, this paper asserts a concentration-stability view that the insurer
interest margin determination and the CEO sunflower management are intimately relevant
to life insurance policyholder protection, and play important channels through which the life
insurance company could have various effects on financial stability[4].
The remainder of this paper is structured as follows. In Section 2, we briefly review the
related literature of sunflower management. Section 3 develops a CEO’s utility function to
analyze the optimal insurer interest margin determination. Section 4 discusses the main
results based on the comparative static analysis of the model. Section 5 concludes.

2. Related literature
Closest to our paper are the following papers classified as three strands of the literature.
First, the seminal work by Merton (1978) on the equity valuation had led to an important
application in the option pricing theory of the insurance literature. For example, Briys and
de Varenne (1994) construct a contingent claim model for the valuation of the equity and the
profit-sharing life insurance policy of a life insurance company where default can only occur
at the maturity date. Grosen and Jørgensen (2002) also construct such a model where they
introduce the risk of premature default to the valuation of life insurance policies. Chen and
Suchanecki (2007) argue that life insurer default cannot be treated as an equivalent event of
life insurer liquidation. The authors develop a contingent claim model to study the impact
of a delayed liquidation on the valuation of the life insurance company’s liabilities. Gatzert
(2008) develops a model for pricing equity and life insurance policies under different
assumptions of asset management and profit-sharing strategies. However, the fair pricing
approaches in the above papers generally only work under the assumption of perfect and
frictionless markets. The current insurance environment where insurance companies
operate on a large scale would be better understood in models using imperfectly competitive
assumption (French and Vital, 2015). This paper attempts to fill the void in the literature by
adding the implementation of market power and CEO sunflower management to the
contingent claim model of the life insurance company.
The second strand is the modern delegation literature on the separation of management
from ownership when insurer managers may have incentives to maximize their own
expected utility based on the revealed preference theory. Behavior compatible with a
risk-averse preference has been observed in many contexts, where it explains deviations
from expected utility models used in the finance and insurance literature (e.g. Braun and
Muermann, 2004; Muermann et al., 2006). Brighetti et al. (2014) focus on whether emotions
RBF and psychological traits can improve the predictability of insurance demand, explicitly
11,3 taking some socioeconomic variables under control. In these papers, the supply-side
management is assumed to be exogenous and individuals’ preferences are assumed to be
consistent with the expected utility theory. However, Jensen and Meckling (1976) argue that
CEOs may have incentives to make decisions based on expected utility maximization.
Within the CEO’s preferences, conflicts of incentives become an issue since the CEO has a
312 substantial amount of his human capital invested in his institution (Fama, 1980). Ishikawa
and Takahashi (2010) find that managerial overconfidence has a strong impact on corporate
financing decisions. Marciukaityte and Szewczyk (2011) show the evidence that managerial
overoptimism affects the choice between debt and equity financing and has a strong impact
on discretionary accruals of firms obtaining substantial external financing. Tarkovska
(2017) finds a negative association between CEO pay slice and corporate performance
measured by Tobin’s q. Hermalin (2005) finds that greater board diligence will lead to
shorter CEO tenures on average, will produce more frequent external hires as CEOs, and
will translate into lower expected utility. For career concerns in the delegation management,
Boot et al. (2005) focus on the sunflower management, the interaction between carrier
concerns and conformity in the context of capital budgeting. What distinguished our work
from the literature is our focus on the commingling of the assessment of the CEO’s
sunflower management in the spirit of Boot et al. (2005) with the assessment of the board’s
belief in the spirit of Hermalin (2005).
The third strand is the literature on insurer interest margin determination. A contingent
claim approach has been employed in the literature to model the ALM of a life insurance
company. A number of writers, e.g., Briys and de Varenne (1994), Grosen and Jørgensen
(2002), Chen and Suchanecki (2007) and Gerstner et al. (2008) have adopted the perfectly
competitive market structure theory as their analytical apparatus. The advantage of this
approach is the explicit treatment of uncertainty, which has played an important role in
discussions of insurer behavior. However, this approach omits a key aspect of insurer
behavior, in particular, when the insurer investment strategy is considered. It is assumed
that invested asset markets by the life insurance company are perfectly competitive so that
quantity-setting is the relevant behavioral in markets. This assumption does not reflect the
reality well since such markets may be highly concentrated where the life insurance
company set rates and face random asset levels. The effect of asset rate-setting behavior can
be treated as an insurer’s investment strategies, which are determined by the duration and
predictability of its liabilities. Lin and Li (2017), particularly focusing on the optimal insurer
interest margin determination, take a contingent claim approach to the market valuation of
equities to study regulatory policies on the consolidation of commercial banking, shadow
banking, and life insurance. With the three strands of literature in place, we contribute the
literature to explore the determinants of optimal insurer interest margins based on a
contingent claim model under the CEO sunflower management. The primary difference
between our model and these papers is that we consider the CEO’s sunflower behavior of a
life insurance company and do not emphasize incentive conflicts among stakeholders due to
the CEO’s career concerns. While we also develop a contingent claim of a regulated life
insurance company, our focus on the sunflower management aspects of CEO utility
valuation takes our analysis in a different direction. In particular, the emphasis we put on is
the interaction between the CEO’s sunflower behavior and spread behavior in the context of
life insurance policyholder protection.

3. Sunflower management model

In this section, we first discuss the CEO’s sunflower preference. Then, the equity function of
the life insurance company is developed based on its balance-sheet specification. Finally, the
instantaneous standard deviation of the return on the life insurance company’s equity and
the default risk in the equity return is derived in order to model the utility function in the Sunflower
sunflower management. management
At the start, a board of directors hires a CEO for the life insurance company. According and life
to empirical evidence, Hermalin and Weisbach (2003) demonstrate that boards play a
significant role in only a few corporate decisions pertaining to the selection, monitoring and insurance
retention of the CEO. The CEO in the basic model developed here is assumed to be informed
that the board makes a decision about whom to hire; a subsequent decision about how 313
intensely to monitor him/her; and a final decision about retaining or firing him/her.
Specifically, the CEO admits that greater board diligence leads to lower CEO expected utility
and shorter CEO tenures. This admission is from an empirical prediction by Hermalin
(2005). To decrease board diligence and hence decrease incentive conflicts as well, the CEO
adopts sunflower management to attempt to confirm the board’s prior belief in the ALM.
In this section, the model is introduced that will be used to analyze the CEO utility aspects of
the life insurance discussed in the Introduction. We begin by examining the optimal insurer
interest margin in a call option utility function setting. To do that, first, we review the basic
model of Briys and de Varenne (1994) succinctly, and more importantly, the loan rate-setting
behavior and earning-asset portfolio substitution are introduced to describe the optimal
insurer interest margin determination. The remaining part of this section focuses on the
valuation of the life insurance company’s equity risk and default probability in order to
formulate the board’s belief and the CEO’s sunflower preference in the model.
A life insurance company whose planning horizon extends over a given time interval
t∈[0, 1] is considered. Suppose the life insurance company has the initial balance shown
in Table I.
Here, the company can allocate between a risky loan A and a risk-free liquid asset B, and
can finance this portfolio with the life insurance policy L and the paid-in capital K.
For simplicity, we assume that the representative policyholder whose premium payment at
t ¼ 0 constitutes the liability of the life insurance company, denoted by L ¼ α(A + B) where
0oαo1 is a leverage variable, and the representative equity holder whose equity is
accordingly denoted by K ¼ (1−α)(A + B) form a mutual company, the life insurance
company. Through their initial investments in the life insurance company, both acquire a
claim on the company’s asset portfolio for a payoff at t ¼ 1. The demand for loans is governed
by a downward-sloping curve A(RA) with the condition of ∂A/∂RA o0 where RA is the loan
rate set by the company[5]. The liquid asset earns the security-market interest rate of RS.
A liability of profit-sharing life insurance policy is that the life insurance company
provides the guaranteed rate of interest plus some surplus on the policyholder’s account.
Specifically, the policyholder is entitled to guaranteed interest rate R and a percentage
(the participation rate, 0oδo1) of the company’s yearly financial revenues. The conditions
of RA WRS and RS WR are generally valid in our model. The former condition indicates the
scope for earning-asset portfolio substitution between risky loans and risk-free liquid assets,
reflecting the asset universe and associated risk-return profiles[6]. The latter one demonstrates
the opportunity cost of insurance protection held by the policyholder. Accordingly, we obtain
the condition of RA W R, implying a positive insurer interest margin in our model.
The life insurance company must invest the premiums it collects from policyholders
and shareholders to pay claims and benefits on its policies and to cover its operating

Asset Liability and equity

Table I.
Loan A Liability L ¼ α(A + B) The life insurance
Liquid asset B Equity K ¼ (1−α)(A + B) company’s balance
Total A+B Total A+B sheet at t ¼ 0
RBF and capital costs. Since the regulated life insurance company is assumed to be insured, the
11,3 company’s policyholders do face the risks that their life insurance contracts will not
perform as initially planned. The shareholders of the life insurance company can walk
away if the company fails. Policyholders are then paid on what is left. The reason is that
the equity holders are the residual claimants on the life insurance company’s asset
portfolio after all other obligations have been met. Specifically, the market value of the
314 company’s underlying assets V is assumed to follow the following stochastic process:
V ¼ mV dt þsV dW ; (1)
where:
V ¼ ð1 þRA ÞA;
and where m and σ denote, respectively, the instantaneous expected return on loan
repayments and the instantaneous volatility. W is a standard Wiener process. The strike
price Z on the underlying asset V is specified the book value of the company’s liabilities
net of the repayment from the liquid-asset investment in our model. This setting is
understood because the default-free liquid assets do not belong to the underlying assets,
which are subject to non-performance. When the value of the company’s underlying assets
is less than the strike price, the value of equity is equal to 0.
First, by applying the call option pricing framework (Briys and de Varenne, 1994), the
market value of the company’s equity is given by:

E ¼ max 0; min½V Z ; ð1daÞV ð1dÞZ  ; (2)
where:

Z ¼ aðAþBÞeR ð1 þRS ÞB;

namely:
 
Z
E ¼ max½0; V Z da max 0; V  : (3)
a
The equity position is a hybrid position and its value as of time t∈[0, 1] is given by:
E ¼ C E ðV ; Z ÞdC E ðaV ; Z Þ; (4)
where:

C E ðV ; Z Þ ¼ V N ðd1 ÞZ eðRS RÞ N ðd2 Þ;

 
1 V s2
d1 ¼ ln þ ðRS RÞþ ; d 2 ¼ d 1 s;
s Z 2

C E ðaV ; Z Þ ¼ aV N ðb1 ÞZ eðRS RÞ N ðb2 Þ;

 
1 aV s2
b1 ¼ ln þ ðRS RÞþ ; b2 ¼ b1 s;
s Z 2
and where N(⋅) is the cumulative density function of the standard distribution. Equation (4)
demonstrates the total payoff to the equity holder at maturity consisting of two call options.
CE(V, Z) is a long call option on the underlying repayment from loan investment with strike Sunflower
equal to the promised payment net of the repayment from liquid-asset investment at management
maturity, called the residual call. This residual call is a limited-liability long call that and life
shareholders have the option to walk away if things go wrong. δCE(αV, Z) is a short call
position, being weighted by the participation coefficient δ, that shareholders have written a insurance
call to policyholders by introducing a contractual asset-based participation clause. This
short call offsets exactly the bonus call option of the liability holder. 315
Second, in the context of our model, the equity of the life insurance company can be
represented as a long call and a short call, as mentioned previously. As the two calls are
deterministic, we apply Ronn and Verma (1986) and let σE stand for the instantaneous
standard deviation of the return on E:
 
@C E ðV ; Z Þ V @C E ðaV ; Z Þ aV
sE ¼ s þd : (5)
@V C E ðV ; Z Þ @aV C E ðaV ; Z Þ
In Equation (5), the first term on the right-hand side can be identified as a loan-repayment
elasticity in a long call position. The second term can be identified as an elasticity of the
payments to policyholders in a short call position. Both the terms are weighted by the
instantaneous expected volatility on loan repayments in the company’s equity risk
valuation. Accordingly, the instantaneous standard deviation of the return on E includes the
deviation of the return on the total payoff to the equity holder as well as to the liability
holder at maturity.
Third, our approach in calculating default risk measures using Merton’s (1974) model is
very similar to the one used by Vassalou and Xing (2004). The default risk is the probability
that the company’s loans will be less than the book value of the company’s net-obligation
payments, according to the given formula of Equation (4), the theoretical probability of
default is given by:
P E ¼ N ðd 3 Þ þdN ðb3 Þ; (6)
where:
   
1 V s2 1 aV s2
d3 ¼ ln þm ; b3 ¼ ln þm ;
s Z 2 s Z 2
and where d3 and b3 tell us by how many standard deviations their ratios need to deviate
from its mean in order for default to occur. It is worthwhile to mention that the equity
value of the two calls in Equation (4) does not depend on m but on RS−R, the probability of
the two cumulative density functions of the standard normal distribution does. This is
because the default probability depends on the future value of loan investment which is
given in the equity function of Equation (4). The equity value is a residual market value,
discounted by RS−R in our model, on the company’s loan repayments after its net-
obligation payments met.
As mentioned previously, boards, in general, make a few corporate decisions, mainly
monitoring their CEOs in the delegation organizations. The choice of a board’s belief in
modeling the life insurance company’s optimization problem remains a controversial issue.
The selection of our model’s belief of the board basically follows Hermalin (2005). With
Equation (4)–(6) in place, we now apply the basic model of Hermalin (2005), and the call
option features with sunflower management are introduced to describe the like and dislike
preferences. Accordingly, the utility of like and the disutility of dislike used by the above-
mentioned author have to be altered because they do not match the needs in our framework.
Indeed, the preferences of the individual directors in Hermalin (2005) can be translated into
RBF the CEO’s preference when the CEO is assumed to behave sunflower management[7]. The
11,3 preference is expressed as if the CEO of the life insurance company has a call-option-based
utility function that positively weights equity returns, but negatively weights equity risks.
Specifically, the utility function has the Cobb–Douglas form:

½ð1P E ÞE b
U ðE; sE Þ ¼ ; (7)
316 ðP E sE Þ1b

where ∂U(E, σE)/∂E W 0 can be explained as the like of higher equity returns, ∂U(E, σE)/∂σE
o0 can be explained as the dislike of higher equity risks, (1−PE) and PE are the weights on
E and σE, respectively, and 0 o β o 1 is the substitution elasticity between the like and
dislike[8]. The higher the β, the more revealed the preference, the like relative to the dislike.

4. Solution and results

This section mainly consists of two parts. The first part presents the optimal solution of the
CEO utility maximization and then derives the comparative static results in the model.
The remaining of this section focuses on discussing the comparative static results by
introducing a numerical analysis.

4.1 Theoretical solution and results

The CEO’s objective is to set RA to maximize the expected value of a call-option-based utility
function of Equation (7), subject to the balance-sheet constraint of Table I. This expression is
globally concave in RA. For convenience, attention will be limited to cases in which
Equation (7) has an interior solution. The first-order condition for Equation (7):

@U ðE; sE Þ
¼ 0; (8)
@RA

namely:
 
@P E @E
b½ð1P E ÞE b1 ðP E sE Þb1 ð1P E Þ
@RA @RA
 
@P E @sE
¼ ðb1Þ½ð1P E ÞE b ðP E sE Þb2 sE þP E ; (9)
@RA @RA
is sufficient, as well as necessary, and admits a unique solution. We require that the
second-order condition of @2 U ðE; sE Þ=@R2A o0 be satisfied. In Equation (9), the term on
the left-hand side can be interpreted as the marginal like of higher equity returns, while
the term on the right-hand side can be interpreted as the marginal dislike of higher equity
risks. As a result, Equation (9) gives the loan rate as the equilibrating variable where both
the marginal like and dislike values are equal.
To capture the response of the equilibrating value of the loan rate (and thus of the optimal
insurer interest margin) to changes in the guaranteed, the participation level, and the
substitution elasticity, one implicitly differentiates the equilibrium condition of Equation (8)
with respect to R, δ and β, which yields the following:

@RA @2 U ðE; sE Þ @2 U ðE; sE Þ

¼ = ; (10)
@R @RA @R @R2A
 @RA @2 U ðE; sE Þ @2 U ðE; sE Þ Sunflower
¼ = ; (11)
@d @RA @d @R2A management
and life
@RA @2 U ðE; sE Þ @2 U ðE; sE Þ insurance
¼ = : (12)
@b @RA @b @R2A
In regulation, Equations (10)–(12) are essential for insurer interest margin management. 317
The added complexity of call options to the Cobb–Douglas utility objective in the model
does not always lead to clear-cut comparative static results. We can determine the results
through a fair combination of the reasonable parameter values in a numerical analysis.
Toward that end, we compute the partial derivatives with respect to R, δ and β by valuing
the following parameters: unless otherwise indicated, α ¼ 0.90, RS ¼ 4.00 percent,
m ¼ RS−R and σ ¼ 0.30. In addition, let (RA(%), A) change from (5.50, 305) to (6.10, 242) due
to the downward-sloping assumption. Let R(%) increase from 2.25 to 3.50; let δ increase
from 0.65 to 0.90; and let β increase from 0.50 to 0.80. There are four alternative levels of
liquid assets, 100, 110, 120 and 130, used in the numerical analysis. We explain the
assumed numerical values as follows:
(1) α ¼ 0.90, σ ¼ 0.30, 2.25⩽R (%)⩽3.50 and 0.65⩽δ⩽0.90 are due to Briys and de
Varenne (1994).
(2) The condition of Ro RS ¼ 4.00%oRA is used in the numerical analysis is due to
Lin and Li (2017).
(3) B ¼ 120, for example, implies that the life insurance company generally holds a
relatively high amount of liquid assets in order to match the needs of the life
insurance policies (Insurance Europe, 2014). For example, a liquid asset-to-loan ratio
is 0.42 when B ¼ 120 and A ¼ 287 in our model.
(4) β increasing from 0.50 to 0.80 indicates the CEO’s revealed preference is relatively
shifting to the like of higher equity return from the dislike of higher equity risk.

4.2 Effect of guaranteed interest rate on the optimal insurer interest margin
We start our analysis with valuing the life insurance company’s alternative objectives of
(1−PE)E and U(E, σE) at various levels of RA through a fair combination of the parameter
values. Three main results are observed in Table II. First, the equity value of the life insurance
company is larger when the objective is the equity maximization than when the objective is
the CEO utility maximization under sunflower management. The intuition is straightforward.

(1−PE)E U(E, σE)

R(%) B ¼ 120 B ¼ 100 B ¼ 110 B ¼ 120 B ¼ 130

2.25 15.7085 3.5334 3.6338 3.7383 3.8470

2.50 15.0250 3.4060 3.5021 3.6019 3.7055
2.75 14.3506 3.2812 3.3732 3.4687 3.5675
3.00 13.6855 3.1590 3.2472 3.3384 3.4326 Table II.
3.25 13.0302 3.0393 3.1238 3.2109 3.3008 Values of (1−PE)E
and U(E, σE)
3.50 12.3850 2.9221 3.0031 3.0863 3.1721
evaluated at its
Notes: Parameter values, unless stated otherwise, α ¼ 0.90, RS ¼ 4.00 percent, σ ¼ 0.30, δ ¼ 0.7 and β ¼ 0.5. approximate optimal
The maximum values of (1−PE)E with various levels of R are evaluated at an approximate optimal RA ¼ 5.60 RA with various
percent when B ¼ 120. The maximum values of U(E, σE) with various levels of R are evaluated at an optimal levels of required
RA ¼ 5.70 percent when B ¼ 100, RA ¼ 5.80 percent when B ¼ 110 or B ¼ 120, and RA ¼ 5.90 percent when B ¼ 130 guaranteed rate
RBF It has been shown that the dislike of higher equity risks is created by the CEO behaving like
11,3 a sunflower and the necessity to model the CEO’s utility function as a call option in a
Cobb–Douglas form. Simply speaking, sunflower management translated into low utility for
the CEO, all else equal. The assessment of the disutility reveals a tendency for the CEO to
ignore his/her own knowledge about risk management and instead attempt to confirm the
board’s prior belief. We refer to this as the opportunity cost of sunflower management. Our
318 argument is based on the assumption justified by noting that the CEO’s ability is the match
between him/her and the job of being CEO. But, both the board and the hired CEO are less
likely to have similar knowledge of risk aspects of ability revealed by prior work experiences.
It is important to recognize that the CEO of the life insurance company has a substantial
amount of his/her human capital invested in the company. Non-conflicts of incentives in an
imperfect labor market can arise due to the sunflower management. Our argument, therefore,
encompasses that of Hermalin (2005).
Second, the optimal insurer interest margin is lower when the objective is the equity
maximization than when the objective is the CEO utility maximization in accordance with
the board’s prior belief. This result is intuitive because the life insurance company can lend
in both the loan and the liquid-asset markets. As loans are subject to non-performance, an
explicit risk premium is charged on the loans to compensate for bearing credit risk if the
CEO behaves the like of higher equity returns and the dislike of higher equity risks
simultaneously. Under the circumstances, the determination of the optimal insurer margin
in the two regimes becomes crucial. An important assumption has been made in our model
that the loan market faced by the life insurance company is imperfectly competitive. In the
objective of equity maximization, the company may attempt to increase its lending at a
reduced loan rate (and thus at a reduced margin) in order to increase its total revenues. In
the objective of the CEO utility maximization with sunflower management, the CEO may
attempt to decrease its lending at an increased loan rate in order to decrease the dislike of
the board, which is ignored in the equity maximization regime. Accordingly, we argue that
the choice of an appropriate goal in modeling the life insurance company’s optimization
problem remains a controversial issue.
Third, it is interesting that, in the CEO utility maximization, the optimal insurer interest
margin is larger when the life insurance company holds a higher percentage of risk-free
liquid assets in its earning-asset portfolio. The result is understood because the CEO may
attempt to augment the like of higher returns and to diminish the dislike of higher risks by
shifting the investments to the liquid-asset market and away from the loan portfolio at an
increased interest margin. As indicated by Insurance Europe and Oliver Wyman (2013),
insurers generally favor default-free asset types because their risk and term profiles satisfy
the demands credited by their relatively illiquid liabilities. Our finding provides an
alternative explanation for this indication.
Our previous results have shown that the alternative objective maximization regimes have
an important determinant of the equity value of the life insurance company. In what follows,
we discuss the effect of the required guaranteed interest rate on the optimal insurer interest
margin only in the case of the CEO utility maximization. We observe from Table III that the
guaranteed rate has a negative effect on the optimal loan rate when the guaranteed rate is at a
low level, while the guaranteed rate has a positive effect on the optimal loan rate when the
guaranteed rate is at a high level. Intuitively, as the life insurance company is regulated to
increase the required guaranteed interest rate, it must now provide a return to a larger base of
policyholder protection. One way the CEO may attempt to increase his/her like of higher
returns as well as to decrease his/her dislike of higher risks is by shifting the investments to
the loan portfolio and away from the liquid-asset market when the required guaranteed
interest rate is at a low level. Under the circumstances, a larger loan portfolio is possible at a
reduced margin if loan demand faced by the life insurance company is relatively rate-elastic.
Accordingly, the level of guarantee that can be offered on life insurance policies affects the Sunflower
insurer interest margins. Insurer investment returns from interest margins under the CEO management
sunflower behavior are an integral part of the life insurance policy itself. and life
French and Vital (2015) consider a number of channels through which insurance
companies could have adverse effects on financial stability, including how their behaviors can insurance
propagate risks in the financial system and then the real economy. According to their
consideration, one immediate application of this research is to evaluate the multiple protection 319
arrangements proposed as alternatives for future life insurance policies, particularly from the
standpoint of financial stability. One frequent suggestion is for the policyholder to hold a life
insurance policy with a high guarantee interest rate. Our results, indicating a transmission
channel of loan risk through the optimal insurer interest margin determination from the life
insurance company to the real economy and financial stability, have provided one explanation
why this should be expected (Table IV ).

4.3 Effect of the participation level on optimal insurer interest margin

It is necessary to elaborate on the participation issue of Equation (11) in our model.
The computed participation effects obtained from Table V are stated as follows: the insurer

(RA(%), A)
R(%) (5.50, 305) (5.60, 302) (5.70, 296) (5.80, 287) (5.90, 275) (6.00, 260) (6.10, 242)

∂RA/∂R, B ¼ 120
2.25→2.50 – −2.2874 −1.5019 −0.8986 −0.6289 −1.5920 –
2.50→2.75 – −2.1876 −1.3279 −0.6267 −0.1813 −0.5041 –
2.75→3.00 – −2.0886 −1.1542 −0.3580 0.2471 0.4219 –
3.00→3.25 – −1.9893 −0.9788 −0.0895 0.6634 1.2376 –
Table III.
3.25→3.50 – −1.8884 −0.8000 0.1820 1.0738 1.9791 – Responsiveness of
Notes: Parameter values, unless stated otherwise, α ¼ 0.90, RS ¼ 4.00 percent, σ ¼ 0.30, δ ¼ 0.7, and β ¼ 0.5. insurer interest margin
The condition of @2 U ðE; sE Þ=@R2A o0 holds for Equation (8). Shaded areas represent the corresponding to required guaranteed
values with an approximate optimal loan rate of 5.80 percent in the CEO utility maximization regime interest rate

(RA(%), A)
δ (5.50, 305) (5.60, 302) (5.70, 296) (5.80, 287) (5.90, 275) (6.00, 260) (6.10, 242)

U(E, σE), B ¼ 120

0.65 4.0601 4.0770 4.0865 4.0887 4.0843 4.0743 4.0608
0.70 3.7085 3.7248 3.7347 3.7383 3.7362 3.7293 3.7198
0.75 3.3798 3.3956 3.4059 3.4108 3.4107 3.4068 3.4009
0.80 3.0720 3.0873 3.0978 3.1038 3.1058 3.1045 3.1020
0.85 2.7829 2.7977 2.8086 2.8156 2.8193 2.8206 2.8211
0.90 2.5110 2.5253 2.5364 2.5444 2.5497 2.5532 2.5565
∂RA/∂δ
0.65→0.70 – −0.1522 0.1103 0.4054 0.8214 1.8464 –
0.70→0.75 – −0.1657 0.1152 0.4346 0.9008 2.1894 –
0.75→0.80 – −0.1840 0.1199 0.4698 1.0029 2.7223 –
0.80→0.85 – −0.2091 0.1238 0.5128 1.1380 3.6598 –
Table IV.
0.85→0.90 – −0.2444 0.1259 0.5663 1.3246 5.7451 –
Responsiveness of
Notes: Parameter values, unless stated otherwise, α ¼ 0.90, RS ¼ 4.00 percent, σ ¼ 0.30, R ¼ 2.25 percent, insurer interest
and β ¼ 0.5. The condition of @2 U ðE; sE Þ=@R2A o 0 holds for Equation (8). Shaded areas represent the margin to
corresponding values with approximate optimal loan rates of 5.80 and 5.90 percent, respectively, in the CEO participation
utility maximization regime coefficient
RBF (RA(%), A)
11,3 β (5.50, 305) (5.60, 302) (5.70, 296) (5.80, 287) (5.90, 275) (6.00, 260) (6.10, 242)

U(E, σE), B ¼ 120

0.50 3.7085 3.7248 3.7347 3.7383 3.7362 3.7293 3.7198
0.55 4.2837 4.3014 4.3096 4.3085 4.2985 4.2805 4.2564
0.60 4.9482 4.9672 4.9731 4.9658 4.9455 4.9132 4.8704
320 0.65 5.7157 5.7361 5.7386 5.7232 5.6900 5.6394 5.5730
0.70 6.6023 6.6239 6.6221 6.5963 6.5464 6.4729 6.3770
0.75 7.6263 7.6493 7.6415 7.6025 7.5318 7.4296 7.2970
0.80 8.8093 8.8333 8.8179 8.7621 8.6655 8.5277 8.3496
∂RA/∂β
0.50→0.55 – 0.4121 −0.5196 −1.6307 −3.3494 −8.3518 –
0.55→0.60 – 0.2869 −0.5073 −1.3922 −2.5531 −4.7055 –
0.60→0.65 – 0.2049 −0.5000 −1.2536 −2.1543 −3.5047 –
0.65→0.70 – 0.1470 −0.4953 −1.1636 −1.9165 −2.9121 –
0.70→0.75 – 0.1039 −0.4922 −1.1010 −1.7600 −2.5623 –
Table V.
0.75→0.80 – 0.0706 −0.4901 −1.0553 −1.6501 −2.3340 –
Responsiveness of
insurer interest Notes: Parameter values, unless stated otherwise, α ¼ 0.90, RS ¼ 4.00 percent, σ ¼ 0.30, R ¼ 2.25 percent, and
margin to substitution δ ¼ 0.70. Shaded areas represent the corresponding values with approximate optimal loan rates of 5.80, 5.70
elasticity and 5.60 percent, respectively

interest margin is increased when the participation level increases. The same pattern as
previously applies. This effect simply reflects a decreasing risky investment at an increased
interest margin determined by the life insurance company for the growing participation
surplus it faces. Accordingly, insurer investment practices are fairly conservation and
investments (mainly default-free assets) are increasingly chosen to fund the expected
pay-out pattern of claims, as pointed by Insurance Europe (2014). Increased participation
level as such makes the life insurance company less prone to risk-taking at an increased
margin, thereby playing an important role in supporting financial stability. French and
Vital (2015) indicate that life insurance companies are strictly regulated by the Prudential
Regulation Authority and Financial Conduct Authority in the UK. The objectives of the
authorities include promoting the safety and soundness of life insurance companies and
securing an appropriate degree of protection for life insurance policyholders. Our result
focusing on sunflower management meets the regulatory objectives of the authorities and
contributes to the literature of insurance and financial stability.

4.4 Effect of substitution elasticity on the optimal insurer interest margin

Our analysis of insurer investment leads to an implication for the CEO’s sunflower
preference, in particular, the degree of the like of higher return relative to the dislike of
higher risk. In most organizations, what we realize are, relatively speaking, different
preferences. We employ Equation (12) in our model to discuss the implications of our
analysis for this degree choice.
The result of Equation (12) as shown in Table V is stated as follows. An increase in the
substitution elasticity decreases the optimal insurer interest margin when the elasticity is
relatively small, while increases the optimal margin when the elasticity is relatively large.
The result is understood because in the CEO utility maximization, the equity value is more
likely to come into effect and the risk value is less likely, as the substitution elasticity
increases. Substitution elasticity as such makes the insurer less prudent and more prone to
loan risk-taking at a reduced interest margin when the substitution elasticity is relatively low,
thereby adversely affecting the stability of the insurance system. Our findings are largely
consistent with Ishikawa and Takahashi (2010), which can be motivated based on an
argument about the managerial irrationality. For a relatively high elasticity level, the optimal Sunflower
insurer interest margin is increasing. The CEO faces a dilemma of the optimal insurer interest management
margin determination when the CEO’s preference matching the board’s belief changes. and life
For most of the analysis, the board’s choice of belief is the degree of the return like
relative to the risk dislike. The CEO’s sunflower preference confirms the board’s belief. Our insurance
results imply the channel of the board’s belief through which the life insurance company
could have different effects on financial stability. A trend toward higher return like of the 321
board’s belief produces a corresponding trend toward the CEO’s increasing risk-taking
when the return like is not strong, while produces a corresponding trend toward the CEO’s
decreasing risk-taking when the return like is strong. The former trend is certainly not what
is expected by the regulatory authorities. Accordingly, we argue that the CEO’s sunflower
management reduces incentive conflicts between the CEO and the board at the cost of not
well utilizing his/her human capital invested in the life insurance company in particular
when the board strongly behaves risk-averse. In conclusion, we show that sunflower
management is intimately relevant to life insurance regulation and financial stability.

5. Conclusion
This paper proposes a contingent claim model for the optimal insurer interest margin
determination based on the recently received sunflower behavior theory of Boot et al. (2005).
This model is developed along the corporate governance of Hermalin (2005) to characterize
the life insurance company’s CEO preferences by a utility function that positively weights
the like measures of equity return, but negatively weights the dislike measures of equity
risk. Specifically, the sunflower preference of the CEO utility function is identical to the
board of directors’ utility. We do this by using a sunflower management framework.
Several new results are derived that should be of interest to investors, supervising
agencies, and policymakers. For example, increasing the regulatory guaranteed interest rate
induces a shift of investment from risky loans to risk-free liquid assets at an increased insurer
interest margin when the guaranteed rate is at a high level. This implies that better life
insurance policyholder protection positively affects the stability of the insurance system. In
addition, increasing the regulatory participation level of the life insurance contract reduces
CEO incentive to take more risk. Furthermore, the CEO faces a dilemma of insurer interest
margin determination when his/her preference revealing the return like relative to the risk of
dislike changes. In conclusion, it is shown that the insurer interest margin determination is
intimately relevant to CEO sunflower management under policyholder protection regulation.

Notes
1. For papers that model ALM, see for instance, Kling et al. (2007), Gerstner et al. (2008) and
Faust et al. (2012), among others.
2. In a recent paper, Lin and Li (2017) make essentially the same argument.
3. This profit-sharing life insurance policy is frequently used in the literature. See, for example,
Briys and de Varenne (1994), Grosen and Jørgensen (2002) and Chen and Suchanecki (2007).
4. The concentration-stability view argues that a highly concentrated market system characterized
by a few large firms (price-setter firms) is more stable than a less concentrated system with many
small firms (price-taker firms). Large price-setter firms in highly concentrated markets are likely to
earn more profits through the implementation of market power (Shim, 2017).
5. As argued by French and Vital (2015), concentration among insurance providers would affect
prospective policyholders’ ability to find alternative providers of insurance cover in the event
of failure of an insurance company. Their argument implies that the asset markets faced by the
life insurance company are also imperfectly competitive. The basic model developed here is to use
this assumption.
RBF 6. An insurer’s investment strategy is generally driven by three main variables: the profile of life
11,3 insurance policies, the asset universe and associated risk-return profiles, and regulatory decisions
(Insurance Europe and Oliver Wyman, 2013).
7. The bargaining setting between the board and the hired CEO is ignored in our model. See Hermalin
and Weisbach (1998) for a bargaining model.
8. It is recognized that the Cobb–Douglas form preimposes the absent situation of weak utility
322 complementarities. For simplicity, we assume the condition of 0 o β o 1 in order to only capture
a relative preference of the equity like β vs the risk dislike (1−β) in our model.

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Corresponding author
Fu-Wei Huang can be contacted at: kwala.wei@mail.tku.edu.tw

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