Academic journal article Journal of Risk and Insurance

Under What Conditions Is an Insurance Guaranty Fund Beneficial for Policyholders?

Academic journal article Journal of Risk and Insurance

Under What Conditions Is an Insurance Guaranty Fund Beneficial for Policyholders?

Article excerpt

ABSTRACT

In this article, we derive conditions in an imperfect market setting, under which the introduction of a self-supporting insurance guaranty fund improves the position of the policyholders. When a guaranty fund is advantageous given homogeneous firms in the market, all policyholders benefit from it to the same extent, if they have the same underlying risk preferences and are charged identical premiums. In a more realistic heterogeneous setting, the introduction of an insurance guaranty fund is in general no longer beneficial for all policyholders in the same manner. Hence, systematic wealth transfers take place between the policyholders of different insurance companies. As a possible solution, and in order to counteract this effect, we introduce a framework for utility-based fund charges.

INTRODUCTION

The magnitude of losses throughout the current financial crisis has even jeopardized the existence of large financial institutions. Insolvency costs caused by the recent turbulence in the international financial markets not only affected equity and debt holders but, through the necessity for major bailouts, also affected taxpayers and the entire society. Regarding the insurance sector, these recent events revealed the need for a general reconsideration of regulation design in general and solvency measurement in particular. See, for example, the current development of the European Solvency II Framework (e.g., CEIOPS, 2009, p. 7), for an overview. Since the aim of solvency regulation and supervision is to reduce the probability of insurer default to a predefined small, yet still positive level, further questions arise with regard to the case of an insurance company default and the coverage of associated insolvency costs. Making taxpayers pay for corporate insolvencies is hard to justify and may incentivize insurers to take more risks.

An insurance guaranty fund financed by all insurance companies in the market can be employed to force insurance companies to internalize the insolvency costs of the entire industry. Its introduction is only one of many possible approaches for the attempt to install a controlled runoff system within the insurance sector. Nevertheless, since insurance companies are not homogeneous and differ in risk brought into the insurance guaranty fund's pool, the calculation of risk-based premiums and the definition of possible payouts from the insurance guaranty fund become a very important task in this context. If these aspects are not considered--as is typically done in insurance practice (1)--adverse incentives for insurers and extensive cross-subsidization between market participants can be expected.

In this article, we examine the conditions under which the introduction of an insurance guaranty fund can be beneficial for policyholders. As a first step, we show that if a contingent claim approach is applied in order to value the claims of the stakeholders of an insurance company, policyholders cannot benefit by the introduction of a fairly designed insurance guaranty fund. As a second step and in an imperfect market setting, we formally show under which conditions an insurance guaranty fund is advantageous for risk-averse policyholders. Possible diversification benefits through the introduction of an insurance guaranty fund are measured by an increase in the utility of the policyholders. The correlation between the payoff of the fund and the assets of the insurer, as well as the premium level in the fund, turn out to be important in order to draw benefits through the introduction of an insurance guaranty fund. If companies are homogeneous and diversification benefits arise through the insurance guaranty fund, the increase in utility is equally allocated to all participating policyholder collectives. However, we find that in the case of heterogeneous companies, an insurance guaranty fund is in general no longer beneficial--at least not to the same extent--for all policyholders of the different insurance companies on the market. …

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