Faculty of Economics and Business Administration Publications Database

Is the Risk-based Mechanism Always Better? The Risk-shifting Behavior of Insurers under Different Insurance Guarantee Schemes

Dong, Ming
Schlütter, Sebastian
Volume: 38
Number: 1
Pages: 72 - 95
Month: Spring
Link External Source: Online Version
Year: 2015
Keywords: Consumer protection; Insurance guarantee schemes; Risk-shifting

Insurance guarantee schemes (IGSs) aim to protect policyholders from the costs of insurer insolvencies. However, IGSs can also reduce the incentives of insurers to conduct appropriate risk management. We investigate the risk-taking behavior of a stock insurer under insurance guarantee schemes with two different financing alternatives: a flat-rate premium assessment versus a risk-based premium assessment. Previous studies indicate that the flat-rate premium assessment can induce insurers to take more risks, a problem that can be resolved under the risk-based premium assessment. Our results show that the risk-taking incentive of the insurer can also occur under the risk-based IGS. The risk-based mechanism is superior to the flat-rate one only if an appropriate premium loading is included. Furthermore, we identify which IGS leads to higher policyholders’ welfare, measured by their expected utility. We find that the risk-based IGS can be more advantageous in improving the policyholders’ welfare due to the limited risk of the insurer, compared to the flat-rate IGS.