Insurance Pricing, Distortions, and Moral Hazard: Quasi-Experimental Evidence from Deposit Insurance

Abstract

Risk-based insurance pricing is often used to address ex ante moral hazard. However, very few studies analyze the effects of differential pricing on insured firms’ behavior or evaluate whether risk-based pricing is effective at mitigating ex ante moral hazard in practice. I exploit a quasi experiment in which deposit insurance premiums were changed for all U.S. banks with staggered timing, generating differentials between banks in both the levels and the risk-based “steepness” of insurance premiums. I find evidence that differentials in premiums resulted in distortions, including regulatory arbitrage, but also provided strong incentives to curb moral hazard. In addition, I find that firms that faced stronger pricing incentives to become (or remain) safer were more likely to subsequently do so than similar firms that faced weaker pricing incentives. The results point to the effectiveness of risk-based pricing and the need that it be governed with robust laws and regulatory controls.