Is the Risk-Based Mechanism Always Better? The Risk-Shifting Behavior of Insurers Under Different Insurance Guarantee Schemes

Abstract

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 di fferent fi nancing 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 only superior to the flat-rate one, if an appropriate premium loading is included. Furthermore, we identify which IGS leads to higher policyholders' welfare, measured by their expected utility. We fi nd 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.