Reserve Levels and Reserve Requirements for Profit-maximizing Insurance Firms

Abstract

Virtually all western countries regulate the reserves of insurance firms, even when they do not directly regulate the premiums charged. The justification for such reserve requirements is usually based on consumer ignorance; it is alleged to be costly if not impossible for a typical consumer of insurance to determine the level of reserves held by insurance firms from which he buys; consequently, consumers would often be unprepared for insurer default.¹ But even if one accepts the premise of consumer ignorance, the premise only implies that reserves regulation may be useful. To show that regulation will be needed to improve things, two additional propositions must hold: (1) If not regulated, firms will hold levels of reserves that deviate from (usually below) the social optimum. (2) Regulators can determine and enforce a level of reserves that is at least closer to the social optimum than the unregulated level. Crucial to the empirical or theoretical establishment of either of these propositions is a positive model which predicts the level of reserves the unregulated firm will choose in different circumstances.