Mispriced risk in insurance and financial markets: causes and consequences

Theoretically, insurance should be beneficial to society. But in practice, insurance systems may become dysfunctional, creating an excessive increase in systemic risk which is detrimental to society. In this paper we use a historical example to illustrate the typical features of a dysfunctional insurance market and construct a model of risk-taking behaviour. We draw parallels with the more recent problems in the credit risk insurance market, which contributed to a sharp increase in systemic risk prior to the Global Financial Crisis in 2008/2009. Construction of a model facilitates assessment of some proposals for reforms.