PROPERTY-CASUALTY INSURANCE GUARANTY FUNDS AND INSURER VULNERABILITY TO MISFORTUNE

Soon-Jae Lee and Michael L. Smith

Research in Financial Economics from Ohio State University

Abstract: This paper presents evidence that the enactment of insurance guaranty fund statutes induced managers of covered insurers to take actions that shifted risk to the guarantor. The mechanism for risk- shifting was a decrease in reserves. The strongest evidence appears for Commercial Multi-Peril insurance, where the enactment of a guaranty fund is associated with a significant decline in a state's loss ratio. Similar effects appear in Homeowners' coverage, although the evidence 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 time-related trends. The observed decline is too large to be explained by the level of guaranty fund assessments. A concluding section of the paper discusses a pricing method 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 experience with pricing methods designed to create incentives for loss prevention.

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