Academic journal article Journal of Risk and Insurance

Monitoring, Ownership, and Risk-Taking: The Impact of Guaranty Funds

Academic journal article Journal of Risk and Insurance

Monitoring, Ownership, and Risk-Taking: The Impact of Guaranty Funds

Article excerpt

ABSTRACT

This study provides evidence regarding the risk-subsidy and monitoring hypotheses by investigating the relation between insider ownership and risk-taking in the property-liability insurance industry. The structure of guaranty funds provides incentives for owners to encourage insurer risk-taking. However, the ex post funding mechanism and incompleteness of guaranty funds may create monitoring incentives that inhibit risk-taking. Moreover, the extent to which managers engage in risk-taking may depend on how well their interests are aligned with those of the owners. The empirical results provide support for the risk-subsidy hypothesis and demonstrate the essential link between insider ownership and risk-taking.

INTRODUCTION

The institutional details of insurance industry guaranty funds have the potential to create competing incentives regarding risk-taking by insurers. Guaranty funds use an ex post financing mechanism to assess surviving insurers for the losses generated by insolvent insurers, and, at the same time, the assessments do not account for the riskiness of the insurers. Lee, Mayers, and Smith (1997) use the risk-neutrality and ex post funding of guaranty funds to develop two hypotheses regarding the impact of guaranty funds on the risk-taking behavior of insurers. They refer to these hypotheses as the risk-subsidy hypothesis and the monitoring hypothesis. They examine the relative strength of these hypotheses, and their empirical evidence leads them to conclude in favor of risk-subsidy.

This study complements the work of Lee, Mayers, and Smith (1997) and addresses several additional issues. For stock market-based measures of risk, the evidence shows that the risk-subsidy hypothesis appears to hold, and the extent of risk-subsidy-related behavior is directly related to insider ownership. This point is related to the ownership structure hypothesis advanced by Lee, Mayers, and Smith (1997). [1] In addition, the authors are able to validate this result by exploiting the option characteristics of the risk-subsidy. Specifically, the study shows that the relation between risk and ownership is stronger for insurers whose put option is closer to being in the money. Finally, as monitoring and risk-subsidy are not mutually exclusive, the authors attempt to avoid a complete dismissal of the monitoring hypothesis by examining a series of piecewise linear relations between risk and ownership. This approach effectively relaxes the condition under which the authors might conclude in favor of the existence o f monitoring. The results appear to have important implications for the effectiveness of guaranty funds and other financial institution insurance programs.

BACKGROUND, THEORETICAL ARGUMENTS, HYPOTHESES

The Insurance Guaranty Fund System

During the years 1969 to 1981, all states enacted laws to establish guaranty funds to protect the policyholders of insolvent insurance companies. [2] The protection provided by these state guaranty funds, however, is far from complete. [3] For instance, the funds typically limit the maximum amount that can be recovered to $300,000 per claim ($100,000 in some states), including all loss adjustment and defense costs. Deductibles are also common. In addition, certain lines of insurance typically have no coverage (e.g., reinsurance and marine insurance), and some states provide no protection for commercial insureds that exceed a particular net worth limit. Beyond these restrictions, payments from a guaranty fund are likely to be delayed compared to payments from a solvent insurer. In addition, guaranty funds do not provide reimbursement for the risk management services that the solvent insurer would have provided.

The funding method used by insurance guaranty fund programs is also very important. Guaranty fund programs are funded on a post-insolvency assessment basis. [4] Thus, surviving insurers are responsible for paying the guaranty fund obligations created when one of their peers becomes insolvent. …

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