Impact of Counterparty Risk on the Reinsurance Market

North American Actuarial Journal, Forthcoming

34 Pages Posted: 7 Jan 2011 Last revised: 24 Jan 2012

See all articles by Carole Bernard

Carole Bernard

Grenoble Ecole de Management; Vrije Universiteit Brussel (VUB)

Michael Ludkovski

University of California, Santa Barbara

Date Written: July 25, 2011

Abstract

We investigate the impact of counterparty risk on contract design in the reinsurance market. We study a multiplicative default risk model, with partial recovery and where the probability of the reinsurer's default depends on the loss incurred by the insurer. The seller is assumed to be risk-neutral while the buyer is risk-averse and uses either expected utility or conditional tail expectation risk criteria. We show that generally the buyer wishes to over-insure above a deductible level and that many of the standard comparative statics cease to hold. We also derive the properties of stop-loss insurance in our model and consider the possibility of divergent beliefs about the default probability. Classical results are recovered when default risk is loss-independent, or there is zero recovery rate. Results are illustrated with numerical examples.

Keywords: Optimal Insurance Design, Multiplicative background risk, Counterparty risk, Reinsurance market, Stop-loss Insurance

JEL Classification: G22, D81, D82

Suggested Citation

Bernard, Carole and Ludkovski, Mike, Impact of Counterparty Risk on the Reinsurance Market (July 25, 2011). North American Actuarial Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1735787 or http://dx.doi.org/10.2139/ssrn.1735787

Carole Bernard

Grenoble Ecole de Management ( email )

12, rue Pierre Sémard
Grenoble Cedex, 38003
France

Vrije Universiteit Brussel (VUB) ( email )

Pleinlaan 2
http://www.vub.ac.be/
Brussels, 1050
Belgium

Mike Ludkovski (Contact Author)

University of California, Santa Barbara ( email )

Santa Barbara, CA 93106
United States

HOME PAGE: http://www.pstat.ucsb.edu/faculty/ludkovski

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