Property-Casualty Insurance Guaranty Funds and Insurer Vulnerability to Misfortune

Soon-Ja Lee and Michael L. Smith

Research in Financial Economics from Ohio State University

Abstract: The presence of third-party guarantees such as insurance guaranty funds can induce managers of covered institutions to take actions that increase the level of risk or increase vulnerability to unfavorable developments. This paper presents evidence of these effects taking place under insurance guaranty funds. The strongest evidence appears for Commercial Multi-Peril insurance, where the enactment of a guarnaty fund is associated with a significant decline in a state's loss ratio. Similar effects appear in Homeowners' Multi-Peril coverage, although evidence for Homeowners' is not as strong as for Commercial Multi-Peril coverage. The observed decline in the loss ratio is not explained by other factors such as state regulation, investment yields, or other time-related trends. The observed decline is too large to be explained by the level of guaranty fund assessments. Understatement of expected future claim payments ("underreserving") offers the most plausible explanation. A concluding section of the paper discusses a pricing model for guaranty fund coverage that could diminish any rewards arising from understatement of future claims. The design of a pricing system could benefit by applying lessons from bank deposit insurance as well as the insurance industry's considerable experience with pricing methods to overcome moral hazards.

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