Knightian uncertainty and insurance regulation decision

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 article characterizes the limited/ imperfect information as Knightian (Risk, Uncertainty, and Profit, Houghton Mifflin, Boston, 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 wrong liquidation with a positive probability. As an illustrative example to fix the wrong 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. © Springer-Verlag 2009.