Guaranty funds and moral hazard in the insurance industry: A theoretical perspective

Abstract

Third-party liability guarantees, such as the guarantees provided by state guaranty funds in the U.S. to property insurance companies, or federal deposit insurance provided to commercial banks in many countries, potentially create risk-taking incentives. Empirical evidence supports the risk-taking hypothesis in property liability insurance and banking. While a large body of literature has focused on the optimal design of regulations to address such moral hazard issues in banking, the potential risk-taking incentives that may arise in the property liability insurance context and their regulatory implications are much less understood. We develop a model that examines an insurance company’s risk-taking incentives in the presence of a guaranty fund that protects policyholders from loss if the insurer fails, a scheme that is provided in many countries.We propose a set of workable regulatory mechanisms that may be considered to alleviate such potential moral hazard incentives.