# Presentation: 513196

## Comments on“Counterparty Risk in Financial Contracts:Should the Insured Worry about the Insurer?”

- Erik HeitfieldFederal Reserve BoardFDIC/JFSR 8th AnnualBank Research Conference
- September 18, 2008

## Paper touches on 3 vital issues

- Credit risk transfer and counterparty risk
- Liquidity risk management
- Overlapping asymmetric information problems

## Counterparty risk

- Bank seeks to transfer credit risk to an insurer
- Insurer manages its own liquidity position given beliefs about the risk of its contingent liabilities
- Outcomes
- If no credit event occurs, the bank receives principal and interest on its exposure and the insurer receives guarantee fee income
- Bank , Insurer 
- If a credit event occurs and insurer is liquid, bank receives principal and interest and insurer bears credit loss
- Bank , Insurer 
- If a credit event occurs and the insurer is illiquid, insurer defaults and bank bears credit loss
- Bank , Insurer ****

## Liquidity management

- Insurer has a liquid asset endowment A
- Invests premium income in a liquid asset L or an illiquid asset I
- Illiquid asset pays higher return: I > L
- But it is not available to pay claims
- Insurer has a contingent liability C
- Endowment is insufficient to pay claim: A < C
- Liquid portfolio is sufficient to pay claim: A + L > C
- Insurer believes claim will occur with probability b

| Insurer Payoffs |  |  |  |
| --- | --- | --- | --- |
|  |  | State |  |
|  |  | Claim (b) | No Claim (1-b) |
| InsurerInvestment | Liquid | A+L-C | A+L |
|  | Illiquid | 0 | A+I |

- Insurer invests premium in I iff:

## Overlappingasymmetric information problems

- Adverse selection
- Bank has better information about the risk of its credit exposure than the insurer
- A bank with a risky exposure has an incentive to lie about the exposure’s credit quality
- Moral hazard
- Insurer determines its liquidity position *after* the insurance contract is negotiated
- Insurer has in incentive to invest in less liquid, higher return assets even though this increases the chances that it will not be able to pay claims

## Equilibrium is not what you’d expect

- Traditional asymmetric information story
- Insurer cannot distinguish between safe and risky exposures, so insurance premiums do not reflect underlying risk
- Likewise, insurer liquidity management is not risk sensitive
- The paper’s result
- The bank truthfully reports the risk of its credit exposure and the insurer believes it
- The insurer invests in more liquid assets if the bank’s credit exposure is high risk

## Intuition

- Counterparty risk depends on insurer’s beliefs
- If the insurer believes that a credit event is likely, it has reason to invest in liquid assets
- If the insurer believes that a credit event is unlikely, it can increase profits at low risk by investing in illiquid assets
- The bank’s cost of bearing counterparty risk depends on the likelihood of a credit event
- A bank with a safer insured exposure is less concerned about counterparty risk because the likelihood of a credit event is lower
- A bank with a riskier insured exposure is more concerned about counterparty risk because the likelihood of a credit event is higher
**Result**: It is more costly for a bank with a risky exposure to report that its exposure is safe
- A bank with a riskier exposure truthfully reports this information, and the insurer believes it
- A bank with a riskier exposure pays higher premiums but bears less counterparty risk

## Problematic Assumption #1Insurer has unlimited liability

- Insurer Asset Value

- Insurer Obligations

- Investment Payoff

- Default Point

**Standard Model**: limited shareholder liability

**Current Model**: bankruptcy costs borne by shareholders with unlimited liability

## Problematic Assumption #2:No coordination problem among banks

- According to the basic model
- Insurer endowed with an initial portfolio of assets and liabilities
- A single credit guarantee contract affects insurer balance sheet in two ways
- Insurer receives up-front fee income held as an asset
- Insurer holds a new contingent liability whose *ex ante* valuation depends on the insurer’s beliefs about the likelihood of a credit event
- After the contract is negotiated, the *only* decision available to the insurer is whether to invest the contract fee income in a liquid/low-yield asset or an illiquid/high-yield asset
- Implication:
- Insurer’s beliefs about a single contingent liability determines its liquidity management
- The bank is the only source new information about this liability
- The bank has a strong incentive and ability to influence insurer beliefs

## Extension to N banks

- Insurer has a liquid asset endowment A
- Invests premium income in a liquid asset L or an illiquid asset I
- Illiquid asset pays higher return: I > L
- But it is not available to pay claims
- Insurer has N contingent liabilities of (C/N) from N banks
- Endowment is insufficient to pay all claims: A < C
- Liquid portfolio is sufficient to pay all claim: A + L > C
- Insurer believes claim i will occur with probability bi

| Insurer payoffs
 |  |  |
| --- | --- | --- |
| Insurer Investment | Liquid |  |
|  | Illiquid |  |

## Investment equilibrium with N banks

- Number of claims n, is a random variable whose probability distribution depends on the insurer’s belief vector (b1...bN)
- Insurer invests in illiquid asset iff:
- When N is large, changing bi alone will have a negligible affect on insurer liquidity decision
- As N∞, no separating equilibrium in idiosyncratic information  possible (Lemma 7)
- Separating equilibrium only preserved if a bank can reveal information about the risk of *other banks’* credit exposures (Lemma 8)
- Assumes systematic shock affects all banks and
- Each bank knows the magnitude of the systematic shock

## Conclusions

- Should the insured care about the insurer?
- YES, YES, YES!
- Does signaling by insured affectinsurer behavior?
- Unlikely
- Insured exposure must be very large relative to other contingent liabilities of the insurer, or
- Insured must have access to information about insurer contingent liabilities not available to the insurer