In this paper, we develop a contingent claim model to evaluate the equity, default risk,
and efficiency gain/loss from managerial overconfidence of a shadow-banking life insurer under the
purchases of distressed assets by the government. Our paper focuses on managerial overconfidence
where the chief executive officer (CEO) overestimates the returns on investment. The investment
market faced by the life insurer is imperfectly competitive, and investment is core to the provision of
profit-sharing life insurance policies. We show that CEO overconfidence raises the default risk in the
life insurer’s equity returns, thereby adversely affecting the financial stability. Either shadow-banking
involvement or government bailout attenuates the unfavorable effect. There is an efficiency gain from
CEO overconfidence to investment. Government bailout helps to reduce the life insurer’s default risk,
but simultaneously reduce the efficiency gain from CEO overconfidence. Our results contribute to the
managerial overconfidence literature linking insurer shadow-banking involvement and government
bailout in particular during a financial crisis.
Relation:
Special issue Financial Risks and Regulation 7(1), 28
