The Role of Monitoring in Reducing the Moral Hazard Problem Associated with Government Guarantees: Evidence from the Life Insurance Industry

State guaranty funds provide partial protection to life insurance holders in the event of an insolvency, thus creating a moral hazard problem akin to the one associated with deposit insurance in the banking industry. We find that differences across states in the financing of these government guaranty systems affects risk taking by life insurance companies (LICs). In states where taxpayers do not pay for the costs of resolving insolvencies, LICs hold portfolios with lower overall stock market risk. These portfolios, however, are characterized by higher levels of both capital and risky assets. These empirical findings have policy implications for improving monitoring of financial intermediaries receiving government liability guarantees. We also examine the effects of franchise value, size and ownership structure on portfolio risk. We find that larger LICs and LICs with more franchise value take less risk. We also find that risk decreases with insider holdings until insiders own about 25 percent of the firm and increases thereafter. This paper was presented at the Financial Institutions Center's May 1996 conference on "