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 thecosts of insurer insolvencies. However, IGSs can also reduce the incentives of insurersto conduct appropriate risk management. We investigate the risk-taking behavior of astock insurer under insurance guarantee schemes with two different financing alter-natives: a flat-rate premium assessment versus a risk-based premium assessment.Previous studies indicate that the flat-rate premium assessment can induce insurers totake more risks, a problem that can be resolved under the risk-based premiumassessment. Our results show that the risk-taking incentive of the insurer can also occurunder the risk-based IGS. The risk-based mechanism is superior to the flat-rate oneonly if an appropriate premium loading is included. Furthermore, we identify whichIGS leads to higher policyholders’ welfare, measured by their expected utility. We findthat 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.