Risk transfer and moral hazard: An examination on the market for insurance-linked securities

Insurance-linked securities provide capital market-based insurance against the risk of natural catastrophes. A challenge arising with the use of those instruments is their sponsor’s potential susceptibility towards moral hazard, which has not been studied in the empirical literature. This study examines whether the sponsors of CAT bonds with indemnity trigger – the currently most prominent type of insurance-linked security – are susceptible to ex-ante moral hazard (i.e., before the occurrence of a catastrophic event) and ex-post moral hazard (i.e., after a catastrophic event). Therefore, we apply panel regression and matching techniques to a comprehensive data set comprising US insurers’ annual statements and information on their activities as CAT bond sponsors. We propose a novel approach to measure moral hazard using the insurers’ loss adjustment expenses. Controlling for the unobserved heterogeneity and time-variant insurer characteristics, we find that sponsors using CAT bonds with indemnity trigger are susceptible to ex-ante moral hazard, but not affected by ex-post moral hazard. We further show that vertical loss retention has a positive effect on sponsors’ incentives to contain losses.