Tags: CAT Bonds, indemnity trigger, insurance-linked securities, moral hazard, EGRIE
More from: Tobias Götze, Marc Gürtler

Moral hazard is one of the biggest challenges faced by insurance market participants, and therefore also receives a lot of attention in academic literature. Typically, two types of moral hazard are distinguished from each other: ex ante moral hazard, which occurs when an insured has incentives to conduct activities that affect the probability of loss before an insurance event and ex post moral hazard, which occurs when an insured has incentives to conduct activities that affect the magnitude of losses after an insurance event. In the present article, we provide a direct test on the presence of ex ante and ex post moral hazard on the market for insurance-linked securities (ILS).

CAT bonds are the currently most prominent type of ILS and provide insurers and reinsurers a capital market-based alternative to conventional reinsurance for the protection against the risk of natural catastrophes. In the last 20 years since its introduction, the market for ILS and CAT bonds in particular has witnessed continuous growth, turning the potential moral hazards on that market into an important subject of research. Until now, moral hazard is only discussed in the literature as a possible factor that affects CAT bond prices, but no study analyzes the actual presence of moral hazard on CAT bond markets.

A major determinant of moral hazard related with the use of CAT bonds is the trigger type, because it defines the payout function of the respective CAT bond contract. If CAT bonds utilize an indemnity trigger, the payout depends on the actual losses incurred by the CAT bond sponsor, whereas with other trigger types, the payout depends on external factors (e.g. catastrophe parameter, loss index). For this reason, theoretical literature implies that CAT bonds with indemnity-based trigger mechanisms (like conventional reinsurance contracts) are subject to information asymmetries and moral hazard, whereas those risks are not present with other trigger types (parametric, index-based, modeled loss). However, the majority of empirical literature shows that the potential risks associated with information asymmetries and moral hazard are not reflected in CAT bond premia.

While moral hazard is discussed in the context of pricing CAT bonds, literature lacks empirical evidence on the existence of moral hazard in the CAT bond market. Evidence from reinsurance markets suggests that moral hazard can be anticipated through contract design and research on the ABS market reflects a relevant moral hazard problem in the relationship between ABS investors and sponsors, because securitization seems to affect the sponsors’ screening and monitoring incentives. The results obtained on other financial markets motivate the research question of this study: Does the use of indemnity triggers lead to moral hazard?

We propose a novel approach by which the insurers’ exposure to moral hazard can be proxied by their federal state-specific loss adjustment expenses. Our analysis is based on a panel data set on the US insurers’ financial statements data, and we proxy moral hazard by the insurers’ federal state-specific defense and cost containment expenses. The data set is supplemented by information on the insurers’ CAT bonds use to control if bonds with an indemnity-based trigger mechanism create a source of moral hazard. As an alternative identification strategy we apply nearest neighbor matching. Our expense-based analysis indicates the presence of ex ante moral hazard for insurers who use CAT bonds with indemnity triggers. This effect is more pronounced in CAT bonds with higher ELs. In contrast, insurers that use CAT bonds with indemnity trigger do not seem to be exposed to ex post moral hazard when a trigger event occurs and they rather tend to have higher loss adjustment expenses in those cases. In addition, we show that the insurers’ exposure to moral hazard when using CAT bonds with indemnity triggers depends on the company size. We also show that the ex ante moral hazard effect does not arise from the unobserved differences between CAT bond sponsors and other companies and that it is persistent in a range of robustness checks.

This study contributes to the actuarial and financial science literature on the potential moral hazard from the use of ILS. We are the first to empirically reveal that the insurers who use CAT bonds with indemnity trigger are subject to ex ante moral hazard, but not ex post moral hazard in terms of loss adjustment expenses. Thus, we point to the importance of both reducing information asymmetries between CAT bond sponsors and investors, and suitably aligning the incentives in CAT bond contracts. We furthermore enhance the understanding of the contradictory results in the theoretical and empirical literature on trigger mechanisms and give a possible explanation as to why indemnity based CAT bonds have not been found consistently priced across empirical studies of the CAT bond market. Ex ante moral hazard related to the use of indemnity-based triggers is conditional on company characteristics such as size and market share, and, therefore, pricing that type of risk is a non-trivial task for investors.

The complete paper is available at:
http://ssrn.com/abstract=3262669.