ALTERNATIVE REGULATORY MECHANISMS IN AN INSURANCE INDUSTRY WITH A GUARANTY FUND

It is widely conjectured that governmentally sanctioned, third-party gua antees of the liabilities of financial institutions are a potential source of moral hazard, resulting in sub-optimal behavior towards risk. State guaranty funds in the insurance industry and federal deposit insurance in banking are examples of such guarantees. Empirical evidence supports the conjecture, finding that risk-tak ng is greater in the presence of guarantees in both commercial bankig1 and property-liability insurance.2 Optimal solutions to the moral hazard problem, and the resulting adverse incentives, are much less understood. To date, policy proposals have been directed almost exclusively to the banking industry. Since the insurance industry and its system of third-party guarantees are considerably different from its counterpart in banking, the solution to the moral hazard problem may also differ considerably. The purpose of this research is to develop a game-theoretic model, under conditions of moral hazard, of the insurance industry and its relationship to regulators, the guaranty fund, and policyholders. The nature of adverse incentives will be examined in this setting. The results should show that the set of workable mechanisms that address the moral hazard problem in insurance have a number of unique differences when compared with the banking industry. Moreover, the results should provide the basis for policy proposals that benefit the insurance industry and those it insures