Insurance Market Regulation

An insurance contract has a strong fiduciary element: the person who buy an insurance
can pay a premium in exchange of a future compensation that will be paid, this because
the buyer do not know the future.

The principal problem of this type of insurance is if the insurer can honor the promise of a
claim by the policy-holder. In this case the most important regulatory system is to prevent
that the enduring has the solvency.

In a big market of insurance in witch insurers had large well-diversified portfolios of

insurance contracts is possible to have an insolvency risks. It can occur when the claim
exceed the net premium income so the insurer need to have a very good reserve to cover
this option.

In case the insurance company can secure this possible claims with a reinsurance company
the need of the mention reserves may reduce but the risks with the own invested
portfolio in where they sub-estimate the possible claims the may need more reserves than
the expected ones.

The regulation of the solvency is necessary because buyer ca not know with certain the
possible insolvent of the insurance company. All of this is important to mention when you
talk about quality of an insurance policy it can exist asymmetric information with this
suppose quality.

So it´s important to mention that this regulation is important for the buyer because of
their lack ok information or uncertain.

Choice of reserves

An insurer that want to maximize their own richness decide the amount of capital to put
in the reserves ( with high levels of reserves to have a cero provability of insolvency, on
the other hand they can decide to not have reserves at all)

All of this models have three assumptions:

1. Reasonable; the insurer has limited liability so is not in their responsibilities to take
claims that pass above the value if their assets. As an example: in developed
countries.
2. The holding capital reserves do not have any cost. Premium income or policy
holders willingness to pay are independent on the amount of capital invested and
also independent of the risk of insolvency.
Supposing that capital cost in reserves exist and also that the required rate of return
increase in the amount raised  the insurance company may find more rentable to
stablish capital in levels of possible insolvency  in favor of regulation.

The optimums point is when:

The marginal cost of capital = marginal increase

If the relation between the first with the second one is high, the reserves will be lower
and higher will be the insolvency risk.

In expected profit resulting from reducing the insolvency probability.

3. A extreme view of the limited rationality and lack of information of the buyers.
Rees try to explain it in an opposite way supposing that consumers have all the
information about the risk of insolvency.
There are to assumptions: the risky buyers and the neutral risk insurance(choose large
enough capital reserves to have zero probability of insolvency) .

The intuitive way of explain this is that a risk adverse buyer will always be prepare to pay
and that a neutral risk insurance will be always prepare to accept the risk of insolvency.

Cost of solvency

When buyers have the information there is no need to have regulation. Also the stress
tests are the one that evaluate its ability to survive in different risk scenarios.

It is more expensive to have a regulatory system with zero insolvency for the consumers
but this helps to eliminate inefficient companies.

Conclusions

The theory confirms that having more information for the consumers in terms of risk of
solvency it would be less necessary to have a big regulation.
So the policy should implement a encouraging for the rating agency to be oriented for the
consumers and for evaluating risk solvency.
Also the regulatory agencies should take the role of collecting, analyzing and giving al the
information to the consumers.