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Counterparty Risk In Insurance Contracts: Should The Insured Worry About The Insurer?

Author

Listed:
  • 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 andmay 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 marketssuch as that of credit derivatives.

Suggested Citation

  • James R. Thompson, 2007. "Counterparty Risk In Insurance Contracts: Should The Insured Worry About The Insurer?," Working Paper 1136, Economics Department, Queen's University.
    • Handle: RePEc:qed:wpaper:1136
    as

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    File URL: https://www.econ.queensu.ca/sites/econ.queensu.ca/files/qed_wp_1136.pdf
    File Function: First version 2007
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    References listed on IDEAS

    as
    1. Bernadette A. Minton & René Stulz & Rohan Williamson, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," NBER Working Papers 11579, National Bureau of Economic Research, Inc.
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    3. Marsh, Ian W & Wagner, Wolf, 2004. "Credit Risk Transfer and Financial Sector Performance," CEPR Discussion Papers 4265, C.E.P.R. Discussion Papers.
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    8. Ajay Subramanian & Robert A. Jarrow, 2001. "The Liquidity Discount," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 447-474, October.
    9. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 25-54, August.
    10. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
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    12. Guillaume Plantin & Jean-Charles Rochet, 2007. "Introduction to When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation," Introductory Chapters, in: When Insurers Go Bust: An Economic Analysis of the Role and Design of Prudential Regulation, Princeton University Press.
    13. James R. Thompson, 2007. "Credit Risk Transfer: To Sell Or To Insure," Working Paper 1131, Economics Department, Queen's University.
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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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    More about this item

    Keywords

    Counterparty Risk; Moral Hazard; Insurance; Banking; Credit Derivatives;
    All these keywords.

    JEL classification:

    • 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
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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