Post by Sapphire Capital on Sept 25, 2008 4:29:22 GMT 4
Knightian Uncertainty and Insurance Regulation Decision
An Chen
Department of Banking and Finance, Falculty of Economics and Law, University of Bonn
August 31, 2008
Netspar Discussion Paper Series No. DP 2008-012
Abstract:
In contrast to insurance companies, regulatory authorities or regulators can obtain only limited information about the companies' value. It hence leads to some effects on the regulation design, which is however often overlooked in the literature. This paper characterizes the limited/imperfect information as Knightian (1921) uncertainty (ambiguity). In order to stress the analytical effects of ambiguity on the regulation decisions, we firstly carry out an analysis in a standard immediate bankruptcy regulation where default and liquidation are considered as indistinguishable events. It is noticed that ambiguity-averse regulators require more "ambiguity equity''. We show then that under ambiguity an immediate liquidation policy delivers false liquidation with a positive probability. As an illustrative example to fix the false liquidation problem under ambiguity, a new regulation rule is developed with a regulatory auditing process. Based on this new model setup, we focus on examining how the riskiness of the firm's value and the debt ratio affect liquidation probability.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1261483
An Chen
Department of Banking and Finance, Falculty of Economics and Law, University of Bonn
August 31, 2008
Netspar Discussion Paper Series No. DP 2008-012
Abstract:
In contrast to insurance companies, regulatory authorities or regulators can obtain only limited information about the companies' value. It hence leads to some effects on the regulation design, which is however often overlooked in the literature. This paper characterizes the limited/imperfect information as Knightian (1921) uncertainty (ambiguity). In order to stress the analytical effects of ambiguity on the regulation decisions, we firstly carry out an analysis in a standard immediate bankruptcy regulation where default and liquidation are considered as indistinguishable events. It is noticed that ambiguity-averse regulators require more "ambiguity equity''. We show then that under ambiguity an immediate liquidation policy delivers false liquidation with a positive probability. As an illustrative example to fix the false liquidation problem under ambiguity, a new regulation rule is developed with a regulatory auditing process. Based on this new model setup, we focus on examining how the riskiness of the firm's value and the debt ratio affect liquidation probability.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1261483