Market Discipline in the Presence of Price Opacity, Product Complexity, and Guaranty Fund Coverage for Life Insurers

ABSTRACT While the presence of deposit insurance from the FDIC is promoted in the banking sector, advertising the existence of similar protection provided via state guaranty funds in the insurance industry is prohibited. With respect to life insurance, such prohibition may stem from concerns over the potential for reduced market discipline in a market characterized by substantial price opacity and product complexity where market discipline already may be limited. We review the theoretical framework of market discipline in relation to insurance guaranty funds and empirically test for the existence of market discipline in the life insurance market. Based on two measures of firm risk, we find almost no evidence of a relationship between insurer risk and life insurance price (and limited evidence of market discipline based on life insurance quantity demanded). Our evidence suggests that market discipline is relatively weak in the life insurance industry, and further that guaranty funds lead to government‐induced moral hazard, further weakening market discipline in life insurance. Our results help explain the existence of prohibitions against advertising the coverage provided by state insurance guaranty funds.