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

We analyze the effect of counterparty risk on financial insurance contracts using the case of credit risk transfer in banking. In addition to the familiar moral hazard problem caused by the insured’s ability to influence the probability of a claim, this paper uncovers a new moral hazard problem on the part of the insurer. 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. We find that counterparty risk can create an incentive for the insured 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. Our research is relevant to the current credit crises and suggests that regulators should be wary of risk being offloaded to other, possibly unstable parties, especially in financial markets such as that of credit derivatives.