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Counterparty Risk in Insurance Contracts: Should the Insured Worry about the Insurer?

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  • James R. Thompson

    ()
    (Department of Economics, Queen's University)

Abstract

We analyze the effect of counterparty risk on insurance contracts using the case of credit risk transfer in banking. In addition to the familiar moral hazard problem caused by the insuree's ability to influence the probability of a claim, this paper uncovers a new moral hazard problem on the other side of the market. We show that the insurer's investment strategy may not be in the best interests of the insuree. The reason for this is that if the insurer believes it is unlikely that a claim will be made, it is advantageous for them to invest in assets which earn higher returns, but may not be readily available if needed. This paper models both of these moral hazard problems in a unified framework. We find that instability in the insurer can create an incentive for the insuree to reveal superior information about the risk of their "investment". In particular, a unique separating equilibrium may exist even in the absence of any signalling device. We extend the model and show that increasing the number of insurers with which the insuree contracts can exacerbate the moral hazard problem and may not decrease counterparty risk. Our research suggests that regulators should be wary of risk being offloaded to other, possibly unstable parties, especially in newer financial markets such as that of credit derivatives.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1136.pdf
File Function: First version 2007
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Bibliographic Info

Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1136.

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Length: 42 pages
Date of creation: Oct 2007
Date of revision:
Handle: RePEc:qed:wpaper:1136

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Keywords: Counterparty Risk; Moral Hazard; Insurance; Banking; Credit Derivatives;

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References

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  1. Duffee, Gregory R. & Zhou, Chunseng, 1999. "Credit Derivatives in Banking: Useful Tools for Managing Risk?," Research Program in Finance, Working Paper Series qt7g67n911, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2004. "Predatory Trading," NBER Working Papers 10755, National Bureau of Economic Research, Inc.
  3. Marsh, Ian W & Wagner, Wolf, 2004. "Credit Risk Transfer and Financial Sector Performance," CEPR Discussion Papers 4265, C.E.P.R. Discussion Papers.
  4. In-Koo Cho & David M. Kreps, 1997. "Signaling Games and Stable Equilibria," Levine's Working Paper Archive 896, David K. Levine.
  5. Ajay Subramanian & Robert A. Jarrow, 2001. "The Liquidity Discount," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 447-474.
  6. Joseph Farrell & Matthew Rabin, 1996. "Cheap Talk," Journal of Economic Perspectives, American Economic Association, vol. 10(3), pages 103-118, Summer.
  7. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  8. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  9. Minton, Bernadette A. & Stulz, Rene M. & Williamson, Rohan, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," Working Paper Series 2005-17, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  10. James R. Thompson, 2007. "Credit Risk Transfer: To Sell or to Insure," Working Papers 1131, Queen's University, Department of Economics.
  11. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  12. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
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Cited by:
  1. Chen, Chang-Chih & Shyu, So-De & Yang, Chih-Yuan, 2011. "Counterparty effects on capital structure decision in incomplete market," Economic Modelling, Elsevier, vol. 28(5), pages 2181-2189, September.

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