Moral Hazard and Guarantee Arrangements: A Case Study of Lloyd’s
State guarantees to insurance policy-holders remove the need for counterparty credit risk assessment and create a moral hazard that may result in excessive risk-exposure and underpricing in the insurance industry. The arrangements at Lloyd’s guaranteeing payment on policies written by individual Lloyd’s syndicates can be expected to have similar effects. An analysis of the behaviour of Lloyd’s in the 1970s and 1980s provides a case study that demonstrates some of the practical consequences of this moral hazard: insurers with insufficient capital resources, excessive exposure to high-volatility catastrophe reinsurance business, and underpricing of risks.
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