State Guaranty Funds Encourage Insurers to Take Excessive Risks

...insolvent property and casualty (P&C) insurance companies tend to have very high growth in premiums in the period before they fail. More than one-third of failed P&C companies had premium growth of more than 50 percent in the two years before failure.

Insurance protects policyholders against risks: for example, given the risk of my home burning down, I purchase fire insurance; in case of a fire, I will be able to recoup at least part of my loss. Analogously, insurance companies and their policyholders are protected against the risk of the insurance companies' failure by state-provided guaranty funds, which act something like the Federal Deposit Insurance Corporation. These state guaranty funds are quasi-governmental agencies that provide insurance to policyholders against the risk of failure of an insurance company. But the existence of guaranty fund insurance, just like other types of insurance, may encourage excessive risk-taking (economists refer to this as a "moral hazard problem"). Insurance companies that are insolvent, or nearly so, may be especially prone to the moral hazard problem since such companies have little to lose if their risky behavior does not pay off.

In The Moral Hazard of Insuring the Insurers (NBER Working Paper No. 5911), James Bohn and Brian Hall point out that, in a sense, insurance companies can borrow money (from policyholders) by writing policies, because there is a time lag between the policyholder's payment of the premium and the company's payout for any insured loss. In what are called "long-tail lines", for example liability insurance, the lag between the premium payment and the expected payout is particularly long. The existence of a guaranty fund enables insurance companies, even risky ones, to borrow from policyholders in this way at rates that do not reflect the default risk of the insurance company. Thus, the insurance companies can "game"(or take advantage of) the guaranty fund system by engaging in excessive premium writing.

Indeed, Bohn and Hall find that insolvent property and casualty (P&C) insurance companies tend to have very high growth in premiums in the period before they fail. More than one-third of failed P&C companies had premium growth of more than 50 percent in the two years before failure. The authors confirm that this excessive growth in premiums was more pronounced in the "long-tail lines." Finally, they find that greater regulatory resources -- more examiners; a bigger budget for the state insurance office -- are associated with less "gaming" of the guaranty fund system.