Regulatory Free Cash Flow and the High Cost of Insurance Company Failures

Abstract

Why is the cost of resolving insurance company failures so high? Evidence in this paper suggests that the state insurance regulatory bodies in charge of the liquidation process turn over an average of only 33 cents for each $1.00 of pre-insolvency assets to the guaranty funds (the state agencies responsible for paying claims). This very low "recovery rate" could result from ex ante regulatory failure -- the assets of the company are not worth much, reflecting regulatory problems prior to liquidation. Or the low recovery rate could reflect ex post regulatory failure -- a regulatory version of the "free cash flow" theory (Jensen, 1986). In this latter case, cash-rich liquidators, who pay their own expenses out of the liquidation receipts first, are reluctant to turn over the money from asset sales to the guaranty funds. The evidence suggests that the low recovery rates arise from both types of regulatory failure.

JEL Classification: G2, G3, G5