Knightian Uncertainty and Insurance Regulation Decision

Abstract: In contrast to insurance companies, regulatory authorities or regulators can obtain only limited information about the companies ’ value. It hence leads to some effects on the regulation design, which is however often overlooked in the literature. This paper characterizes the limited/imperfect information as Knightian [1921] uncertainty (ambigu-ity). In order to stress the analytical effects of ambiguity on the regulation decisions, we firstly carry out an analysis in a standard immediate bankruptcy regulation where default and liquidation are considered as indistinguishable events. It is noticed that ambiguity-averse regulators require more “ambiguity equity”. We show then that under ambiguity an immediate liquidation policy delivers false liquidation with a positive probability. As an illustrative example to fix the false liquidation problem under ambiguity, a new regulation rule is developed with a regulatory auditing process. Based on this new model setup, we focus on examining how the riskiness of the firm’s value and the debt ratio affect liquidation probability