State guaranty fund system and price implications.

Author:Choi, Byeongyong Paul

    For the past decades, the insurance industry has observed various changes in economic conditions and changes in regulatory factors. The technological advancement and advances in financial engineering could change the way of insurers' doing business in various ways. Moreover, the trends of mergers and acquisitions generally affect the market structure, especially firm size and growth rate. Along with firm growth, failure of financial intermediaries may generate adverse consequences in the industry and then public concerns arise regarding this matter. In the insurance area, to protect the policyholders and other beneficiaries of policies due to the resulting insolvency of insurers, a guaranty fund system has been created and implemented for the current system since late 1960s. As a result, the presence of guaranty funds has affected the business of various sizes of insurers, especially smaller firms.

    Small firms are surviving in the U.S. property and liability (P-L) insurance industry and the guaranty fund system may provide a positive impact on the persistence of small firms in the market. The guaranty fund law, which may help small firms more, protects up to $300,000 in most states and the protection cap has remained the same since 1981. However, the real value of state protection has declined over time. Then, the relatively reduced protection from the guaranty fund may adversely affect smaller firms' operation since large accounts are seeking large and stable insurers because the coverage guaranteed by the law is well below their desired protection. This research question can be tested empirically and this paper examines the impact of decreased levels of real guaranty fund protection on insurers' prices for large and small P-L insurance firms.

    A company level analysis is used for the period of 1992 to 2000. Based on total assets, U.S. P-L insurers are divided into two groups, small insurers and large insurers, and then the impact of guaranty fund system on insurance prices is tested for the two groups. Also, it is tested for the two different sub-periods, 1992-1996 period and 1997-2000 period, based on the underwriting profit cycle.

    This research is the first study to examine the potential impact of the guaranty fund system on firms of different sizes. Empirical results of this paper will provide useful information on the public policy issue on firms' activities of different sizes in the U.S. P-L insurance industry.


    One of common causes of P-L insurers' failures is rapid overexpansion and diversification along with managerial inefficiencies. For an obvious reason, insurance industry concerns are about the insolvency of insurance firms. Since 1969, as a result, a guaranty fund has been developed to protect the parties in the insurance contract if an insurer goes bankrupt. By year 1981, every state has enacted its own guaranty-fund law. The coverage provided by the guaranty fund is limited and most states follow the model law suggested by the National Association of Insurance Commissioners (NAIC). On average, the guaranty-fund law covers up to $300,000 in most states and the amount of coverage hasn't been changed in over three decades.

    There were no prior studies to examine the relationship between the guaranty fund system and insurance prices. Many studies, however, focused on the impact of guaranty fund on the firm risk-taking behavior (e.g., Cummins, 1988, Lee, Mayers and Smith, 1997, and Downs and Sommer, 1999). Cummins (1988) argued that the guaranty fund system should be changed to risk-based assessment to reduce high-risk strategies which were caused by the current flat premium rate assessment in which the level of firm's risk was not linked to the assessment. Lee, Mayer and Smith (1997) asserted the risk-subsidy hypothesis and provided evidence from stock companies. Under the risk-subsidy hypothesis, the enactment of state guaranty fund law has increased the risk of insurers' asset portfolios. Downs and Sommer (1999) examined the risk-subsidy hypothesis for the stock companies with the perspective of inside ownership structure. They also support the risk-subsidy hypothesis and find a positive relationship between the inside ownership and risk-taking behavior.

    Unlike other prior research, this paper directly addresses the impact of the state protection system on P-L insurers' operation. Since the nominal value of state protection was unchanged at $300,000, the real value of guaranty funds has declined over time. By year 2002, the real value has dropped more than 50 percent of the original value started in 1981. The limited and declined real value of guaranty fund protection impacts on the large accounts that need more than the statutory coverage. So, their tendency is to seek large and well-established insurers who may have a conventional conception of 'Too Big To Fail.' Consumers also tend to find financially sound firms because of limited protection (Klein and Barth, 1995). Furthermore, there exists a prevailing perception that small insurers are riskier than larger insurers. Hence, the decreased level of guaranty fund protection might adversely affect small firms. That is, there might be a tendency to decrease prices to mitigate the increased risk due to decreased protection from the safety net (see Epermanis and Harrington, 2006). The impact might be greater for smaller firms since their business is more tied to guaranty fund protection.

    In summary, we can state the following testable hypothesis for P-L insurers:

    Hypothesis 1. Since insurers have to mitigate the risks, the decreased level of guaranty fund protection negatively impacts on insurers' prices. The price reduction is relatively higher for small insurers compared to large insurers.

    The P-L insurance industry generally experiences an underwriting cycle measured by the industry's combined ratio (see Figure 1). A value of 100 indicates a break-even point and high value of the combined ratio indicates losses from underwriting performance. More competition and price reductions are characterized during the period when the underwriting cycle is downward, i.e., 1992-1996 period. On the other hand, less competition and rising prices are commonly found during the period when the underwriting cycle is upward trend, i.e., 1997-2000 period. Browne and Hoyt (1995) and Kleffner and Lee (2009) show a high correlation between the underwriting cycle and insurers' insolvency. Thus, we expect that the impact of the guaranty fund system on prices is different for the different underwriting cycles in the following way:

    Hypothesis 2. The impact of guaranty fund protection is greater during the period when the industry experiences poor underwriting performance compared to the period when the industry experiences improved underwriting profits.


    3.1 Data

    Various firm-specific variables are obtained from the Annual Statement from...

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