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Separation Without Mutual Exclusion in Financial Insurance

Author

Listed:
  • Stephens, Eric

    (University of Alberta, Department of Economics)

  • Thompson, James

    (University of Waterloo)

Abstract

In traditional economic models of insurance, sellers typically employ a non-linear pricing scheme to elicit type information from buyers. In financial insurance contracts, such a policy is not possible since contracts are non-exclusive. In addition, counterparty risk in financial contracts can be particularly problematic relative to traditional insurance. Accordingly, we relax the standard assumption of contract exclusivity and allow the insured to contract with many sellers, some of which may be unstable. In contrast to the traditional insurance model, we show that separation of risk types among insured parties can be achieved with linear pricing when there is aggregate counterparty risk. This result is shown to collapse when contracts are cleared through a central counterparty, suggesting that such an arrangement can create opacity.

Suggested Citation

  • Stephens, Eric & Thompson, James, 2012. "Separation Without Mutual Exclusion in Financial Insurance," Working Papers 2012-8, University of Alberta, Department of Economics.
    • Handle: RePEc:ris:albaec:2012_008
    as

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    File URL: https://sites.ualberta.ca/~econwps/2012/wp2012-08.pdf
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    References listed on IDEAS

    as
    1. Cummins, J David & Mahul, Olivier, 2003. "Optimal Insurance with Divergent Beliefs about Insurer Total Default Risk," Journal of Risk and Uncertainty, Springer, vol. 27(2), pages 121-138, October.
    2. James A. Ligon & Paul D. Thistle, 2005. "The Formation of Mutual Insurers in Markets with Adverse Selection," The Journal of Business, University of Chicago Press, vol. 78(2), pages 529-556, March.
    3. Stephens, Eric & Thompson, James R., 2014. "CDS as insurance: Leaky lifeboats in stormy seas," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 279-299.
    4. Neil A. Doherty & Harris Schlesinger, 1990. "Rational Insurance Purchasing: Consideration of Contract Nonperformance," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 105(1), pages 243-253.
    5. Michael Rothschild & Joseph Stiglitz, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 90(4), pages 629-649.
    6. John David Cummins & Olivier Mahul, 2003. "Optimal insurance with divergent beliefs about total default risk," Post-Print hal-01952121, HAL.
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    8. Smith, Bruce D & Stutzer, Michael J, 1990. "Adverse Selection, Aggregate Uncertainty, and the Role for Mutual Insurance Contracts," The Journal of Business, University of Chicago Press, vol. 63(4), pages 493-510, October.
    9. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
    10. Richard D. Phillips & J. David Cummins & Franklin Allen, 1996. "Financial Pricing of Insurance in the Multiple Line Insurance Company," Center for Financial Institutions Working Papers 96-09, Wharton School Center for Financial Institutions, University of Pennsylvania.
    11. Bertrand Villeneuve, 2003. "Mandatory Pensions and the Intensity of Adverse Selection in Life Insurance Markets," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 70(3), pages 527-548, September.
    12. James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 125(3), pages 1195-1252.
    13. Robert R. Bliss & Robert Steigerwald, 2006. "Derivatives clearing and settlement: a comparison of central counterparties and alternative structures," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 30(Q IV), pages 22-29.
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    1. Stephens, Eric & Thompson, James R., 2014. "CDS as insurance: Leaky lifeboats in stormy seas," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 279-299.

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    More about this item

    Keywords

    insurance; separation; mutual exclusion; counterparty risk;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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