Too Old to Fail: Risk Perception and Market Discipline

Abstract

This paper studies the impact of lenders’ sensitivity to a change in company risk and public insolvency guarantees, on market discipline in life insurance during the 1985-2010 period. We find strong market discipline for young insurers but not for older insurer, supporting the strong influence of risk insensitive lenders due their trust attached to individual insurers. Furthermore, by exploiting the variation in the creation of guaranty funds by 16 states during the sample period, we find robust evidence that the market discipline in young insurers has been dampened by guaranty funds, while such moral hazard is not observed in old insurers. We also find some evidence to suggest that company risk increases with lender trust but little evidence of the influence of guaranty fund coverage on risk-taking in the US life insurance industry.