Solvency Regulation in the Property-Liability Insurance Industry

Article excerpt

Abstract

This paper evaluates guaranty funds and solvency regulations. One main question addressed is how solvency regulations will benefit consumers. Many previous studies have found that most forms of solvency regulations do not have significant deterrent effects on insolvency. Even when solvency regulations are effective, they might still adversely affect consumers. This could happen because increasing the probability of solvency usually requires raising premiums. Therefore, it is interesting to see how regulators should design insurance regulations that benefit consumers. Insolvency of insurance firms provides a unique environment under which one is able to analyze the effects of solvency regulations and guaranty funds on the quality of insurance products and on consumers. This paper shows that guaranty funds are always desirable, but solvency regulations are of certain value only when they have the effect of protecting guaranty funds and alleviating the disincentives which they create. (JEL G22)

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Introduction

Because of the increase in insolvencies of insurance firms in recent years, (1) the effectiveness of insurance guaranty funds and solvency regulations (2) has been questioned [Jackson, 1990; U.S. House, 1990; Power, et. al., 1991; Schacht and Gallanis, 1993]. Some proposals have been put forward to reform the current regulatory system. One suggestion is to have more interstate cooperation and to form interstate compacts of guaranty funds [Jackson, 1990; Schacht and Gallanis, 1993]. The other is to have more federal intervention, which includes setting up a national guaranty fund similar to the federal deposit insurance system and regulating insurance firms through the federal government [U.S. House, 1990]. However, the necessity and effectiveness of such reforms, and particularly that of federal intervention, have been doubted.

This paper evaluates guaranty funds and solvency regulations. One main question addressed is how solvency regulations will benefit consumers. Many previous studies have found that most forms of solvency regulations do not have significant deterrent effects on insolvency [Munch and Smallwood, 1980; Lee, 1994]. Even when solvency regulations are effective, they might still hurt some consumers [Doherty and Schlesinger, 1990]. This could happen because increasing the probability of solvency usually requires raising premiums. Therefore, it is interesting to see how regulators should design insurance regulations to benefit consumers.

This study can be viewed as an extension of the studies of regulatory effects on quality of products and on consumers. Here the quality of insurance products is measured by the firm's probability of solvency and its ability to pay claims. Economists have long been interested in such studies. Spence [1975] finds that when firms have the monopoly power to set both the price and quality of products, they tend to set quality too low. He further concludes that rate of return regulation will force firms to raise quality and thereby benefit consumers, provided quality is a capital-using attribute. Many previous studies have focused on the effects of regulations on the quality of insurance services, instead of the quality of the product itself. Findings from these studies have been controversial. For instance, Frech and Samprone [1980] find that rate regulation in property-liability insurance leads to nonprice competition, i.e. competition centering on the quality of services. However, Pauly, Kunreuther, and Kleindorfer [1986] find that rate regulation reduces the average price of many types of insurance and lowers the quality of insurance services. They conclude that the welfare effects of such regulation are not clear and need to be explored further. (3)

Insolvency of insurance firms provides a unique environment under which one is able to analyze the effects of solvency regulations and guaranty funds on quality of insurance products and on consumers. …