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The Moral Hazard of Insuring the Insurers

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  • James G. Bohn
  • Brian J. Hall

Abstract

State guaranty funds are quasi-governmental agencies that provide insurance to policyholders against the risk of insurance company failure. But insurance provided by guaranty funds, like all insurance, creates moral hazard problems, especially for companies that are insolvent or near-insolvent. The key insight of this paper is that because of the time lag between premium payments and losses (which is especially lengthy in long-tail lines), writing policies is one way for insurance companies to borrow money (i.e., from policyholders). Moreover, the existence of guaranty fund insurance enables insurance companies, even very risky ones, to borrow from policyholders at rates that do not reflect the insurer's default risk. Thus, one way for insurance companies to game the guaranty fund system is to engage in excessive premium writing. Consistent with this idea, we find that insolvent P&C insurance companies tended to have very high premium growth before they failed. More than one-third of the failed insurance companies had premium growth of more than 50 percent in the two years before failure. Moreover, this excessive premium growth was more pronounced in long-tail lines than in short-tail lines. We also find evidence that greater regulatory resources are associated with less gaming of the system.

Suggested Citation

  • James G. Bohn & Brian J. Hall, 1997. "The Moral Hazard of Insuring the Insurers," NBER Working Papers 5911, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:5911
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    References listed on IDEAS

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    1. Cummins, J David, 1988. " Risk-Based Premiums for Insurance Guaranty Funds," Journal of Finance, American Finance Association, vol. 43(4), pages 823-839, September.
    2. James, Christopher, 1991. " The Losses Realized in Bank Failures," Journal of Finance, American Finance Association, vol. 46(4), pages 1223-1242, September.
    3. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    4. Brian J. Hall, 1996. "Regulatory Free Cash Flow and the High Cost of Insurance Company Failure," Harvard Institute of Economic Research Working Papers 1782, Harvard - Institute of Economic Research.
    5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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    Cited by:

    1. Brian J. Hall, 1998. "Regulatory Free Cash Flow and the High Cost of Insurance Company Failures," NBER Working Papers 6837, National Bureau of Economic Research, Inc.

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