Counterparty Risk in Financial Contracts: Should the Insured Worry About the Insurer?
James R. Thompson
University of Waterloo - School of Accounting and Finance
October 26, 2009
We analyze the effect of counterparty risk on financial insurance contracts, using the case of credit risk transfer in banking. This paper posits a new moral hazard problem on the insurer side of the market, which causes the insured party to be exposed to excessive counterparty risk. We find that this counterparty risk can create an incentive for the insured party to reveal superior information about the likelihood of a claim. In particular, a unique separating equilibrium may exist, even in the absence of any costly signalling device.
Number of Pages in PDF File: 47
Keywords: Counterparty Risk, Moral Hazard, Banking, Credit Derivatives, Insurance
JEL Classification: G21, G22, D82
Date posted: October 6, 2008 ; Last revised: May 14, 2011