Cash reserve policy, regulation and credibility in insurance

Abstract

The aim of this paper is to analyze the need for cash and default regulation in nsurance. Proponents of deregulation argue that these requirements are useless as insurers would hold enough cash as soon as policyholders are fully informed about their default probability. Adding to the purpose the relationship between an insurer and her security holders (that is the issuance and dividend policy), we show that the second best (credible) cash reserve decided by the securityholders is suboptimal whenever the return on cash inside the firm is smaller than outside. Because of limited commitment on recapitalization, disclosure of information may not be enough. Given these characteristics, State commitment to recapitalize could be an alternative regulation policy.