Risk Transfer and Moral Hazard: An Examination on the Market for Insurance-Linked Securities

Abstract

Evidence on the existence of moral hazard on the market for insurance-linked securities is ambiguous. This study examines whether the sponsors of CAT bonds with indemnity trigger – the currently most prominent type of insurance-linked security – are susceptible to ex ante moral hazard (i.e., before the occurrence of a catastrophic event) and ex post moral hazard (i.e., after a catastrophic event). Therefore, we apply panel regression and matching techniques to a comprehensive data set comprising US insurers’ annual statements and information on their activities as CAT bond sponsors. We propose a novel approach to measure moral hazard using the insurers’ loss adjustment expenses. Controlling for the unobserved heterogeneity and time-variant insurer characteristics, we find that sponsors using CAT bonds with indemnity trigger are exposed to ex ante moral hazard, but not affected by ex post moral hazard.

Keywords: CAT Bonds, Indemnity Trigger, Insurance-Linked Securities, Moral Hazard

JEL Classification: G22, G23, G32