Contract Nonperformance Research Articles

Bank stability and the price of loan commitments

Firms insure themselves from liquidity shocks by contracting on credit lines from banks. I document novel empirical evidence on how the risk of contract nonperformance by banks is priced. Firms pay a higher price for loan commitments from safer banks. A one standard deviation increase in the cross-sectional mean of bank capital increases the commitment fees by 5%. To investigate a potential causal effect of lender stability on commitment fees, I exploit exogenous variation in the market value of banks’ assets from natural disasters. The sensitivity of the fees is higher for firms with higher short-term liabilities and higher income uncertainty.

Investment, insurance and weather shocks: Evidence from Cambodia

The livelihoods of poor people in developing countries are increasingly dependent on weather shocks whose effects are exacerbated by the lack of access to adequate insurance markets allowing risk hedging. Index-based insurance underwrites a weather risk as a proxy for economic loss: when the index falls below a certain level, farmers automatically get a payment. The aim of this paper is to study the impact of an Index-based insurance on investment decisions in profitable but risky inputs in presence of weather shocks by means of an incentivized lab-in-the-field experiment conducted in Cambodia. The protocol is designed so as to study the extent to which investment decisions change under risk or ambiguity, for different levels of initial wealth, under contract nonperformance (i.e., when claims are not repaid by the insurer) and when the insurance is fully subsidized. The findings indicate that, while the mere presence of a market for insurance increases investment, the strength of the effect crucially depends upon the level of initial wealth and upon the subjects' ability to correctly assess the probability of a shock.

Do you trust your insurer? Ambiguity about contract nonperformance and optimal insurance demand

Abstract We study optimal insurance demand for a risk- and ambiguity-averse consumer under ambiguity about contract nonperformance. Ambiguity aversion lowers optimal insurance demand and the consumer’s degree of ambiguity aversion is negatively associated with the optimal level of coverage. A more pessimistic belief and greater ambiguity may increase or decrease the optimal demand for insurance, and we determine sufficient conditions for a negative effect. We also discuss wealth effects and evaluate the robustness of our results by considering several alternative models of ambiguity aversion. Our findings show how ambiguity about contract nonperformance can undermine the functioning of insurance markets, making it a concern for regulators. Caution is required though because demand reactions are only imperfectly informative about the welfare effects of ambiguity about contract nonperformance.

Optimal Insurance Demand When Contract Nonperformance Risk Is Perceived As Ambiguous

We study optimal insurance demand for a risk- and ambiguity-averse consumer under ambiguity about contract nonperformance. Ambiguity aversion lowers optimal insurance demand and the consumer's degree of ambiguity aversion is negatively associated with the optimal level of coverage. A more pessimistic belief and greater ambiguity may increase or decrease the optimal demand for insurance, and we determine sufficient conditions for a negative effect. We also discuss wealth effects and evaluate the robustness of our results by considering several alternative models of ambiguity aversion. Our findings show how ambiguity about contract nonperformance can undermine the functioning of insurance markets, making it a concern for regulators. Caution is required though because demand reactions are only imperfectly informative about the welfare effects of ambiguity about contract nonperformance.

Contract Nonperformance Risk and Ambiguity in Insurance Markets

Insurance contracts may fail to perform, leading to a total or partial default on valid claims. We extend models of such probabilistic insurance to allow for ambiguity in contract nonperformance risk, and derive formally that mean-preserving ambiguity reduces demand. The results of a field lab experiment are consistent with this logic. In particular, we find that a 10 percent contract nonperformance risk reduces insurance demand by 17.1 percentage points even when premiums are adjusted accordingly. Ambiguity about this contract nonperformance probability further decreases demand by 14.5 percentage points. While the demand-reducing effect of ambiguity is more pronounced for high-numeracy and ambiguity-averse individuals, it appears to be little affected by experience. The cause of an insurance contract failing to perform does not significantly influence the strength of these effects, but independently affects demand of low-numeracy and ambiguity-averse individuals.

Improved water allocation utilizing probabilistic climate forecasts: Short‐term water contracts in a risk management framework

Probabilistic, seasonal to interannual streamflow forecasts are becoming increasingly available as the ability to model climate teleconnections is improving. However, water managers and practitioners have been slow to adopt such products, citing concerns with forecast skill. Essentially, a management risk is perceived in “gambling” with operations using a probabilistic forecast, while a system failure upon following existing operating policies is “protected” by the official rules or guidebook. In the presence of a prescribed system of prior allocation of releases under different storage or water availability conditions, the manager has little incentive to change. Innovation in allocation and operation is hence key to improved risk management using such forecasts. A participatory water allocation process that can effectively use probabilistic forecasts as part of an adaptive management strategy is introduced here. Users can express their demand for water through statements that cover the quantity needed at a particular reliability, the temporal distribution of the “allocation,” the associated willingness to pay, and compensation in the event of contract nonperformance. The water manager then assesses feasible allocations using the probabilistic forecast that try to meet these criteria across all users. An iterative process between users and water manager could be used to formalize a set of short‐term contracts that represent the resulting prioritized water allocation strategy over the operating period for which the forecast was issued. These contracts can be used to allocate water each year/season beyond long‐term contracts that may have precedence. Thus, integrated supply and demand management can be achieved. In this paper, a single period multiuser optimization model that can support such an allocation process is presented. The application of this conceptual model is explored using data for the Jaguaribe Metropolitan Hydro System in Ceara, Brazil. The performance relative to the current allocation process is assessed in the context of whether such a model could support the proposed short‐term contract based participatory process. A synthetic forecasting example is also used to explore the relative roles of forecast skill and reservoir storage in this framework.

Insurer Contract Nonperformance in a Market with Adverse Selection

ABSTRACT In this study we examine the impact of insurer contract nonperformance upon Wilson's adverse selection equilibrium where consumers exhibit constant absolute risk aversion. When the market equilibrium retains its original form (i.e., pool or separation), premiums and coverage levels generally fall, although the change in coverage level for good risks is ambiguous when the equilibrium is separating. When the market equilibrium changes form, the change in premium and coverage levels is generally ambiguous, although one can determine that good risk premiums go down when the equilibrium shifts from pooling to separating and that bad risk premiums and coverage levels go down when the equilibrium shifts from separating to pooling. Interestingly, we find that although the introduction of insurer default risk makes good risks worse off, this is not necessarily true for bad risks. Bad risks can be better off because the decrease in the price differential between types can make pooling relatively attractive to good risks in the presence of default risk. INTRODUCTION In a world with complete insurance markets, a risk adverse individual, facing fair prices, will fully insure her wealth across all states of the world. When insurance markets are incomplete, this result need not hold, and an individual's behavior will depend, among other things, upon the correlation of insurable and non-insurable risks (Doherty and Schlesinger, 1983a, 1983b; Mayers and Smith, 1983). The breakdown in the standard analysis is perhaps most severe when the uninsurable risk is itself created by the purchase of insurance, that is when there is a risk of contract nonperformance by the insurer.' Doherty and Schlesinger (1990) show that a risk averter will not purchase full coverage at fair prices, that coverage purchased is not, in general, a monotonic function of the risk of insurer default, coverage purchased is not necessarily negatively related to the level of loading, individuals who are more risk averse (in the sense of Ross,1981) need not purchase insurance, and (when default is partial) there is no monotonic relationship between the level of coverage and the extent of recovery. The consequences of contract nonperformance upon standard insurance results are thus quite severe. It is also well recognized in the literature that the operation of insurance markets is significantly affected by adverse selection (e.g., Rothschild and Stiglitz, 1976, Wilson, 1977, and Spence, 1978). Wilson's (1977) model of adverse selection suggests that the equilibrium will either involve a pooling contract or a pair of separating contracts. If a pool results, it provides the coverage level optimal to the good risks at the pool price. Separation occurs when the better risks prefer a limited coverage contract (with the better risk coverage level sufficiently limited that higher risks prefer a full coverage contract at a price fair to the higher risks) at a price fair to the better risks to any contract at a price fair to the overall pool. Adverse selection insurance markets may be significantly impacted when background risk (Agarwal, 1995) or severity risk (Doherty and Schlesinger, 1995; Ligon and Thistle, 1996) are present. The primary difference between these studies and ours is the correlation between insurable losses and the additional risk introduced; we explore the impact of contract nonperformance upon a market with adverse selection. We analyze the impact of the introduction of a third (default) state of the world upon the nature of the Wilson equilibrium (pooling or separating), including its impact on the level of coverage, the premium paid, and societal welfare. We find, as did Doherty and Schlesinger (1990), that contract nonperformance often generates indeterminate results compared to standard models, even with strong restrictions on preferences. However, these ambiguities imply that nonperformance may have a surprising impact on insurance markets, including the possibility that some consumers may be better off in the presence of default risk. …

Contractor Failure: Analysis

The possibility exists for any construction contractor to fail to filfill the contract requirements associated with a facility. Contractor failure occurs when a contractor is unable to perform his/her contractual duties, thus requiring the facility owner to invoke the contract's nonperformance clause. This paper provides aggregate contractor business failure statistics and outlines potential causes for failure. A framework to identify and quantify the associated costs is also introduced. Several case studies are presented to examine the cause and cost of failure and the means by which the facilities were completed. Alternatives available for project completion when contractor failure occurs are discussed. Recommendations to identify and monitor contractors at high risk for failure are outlined as well. This paper provides facility owners with a greater awareness of the possibility of contractor failure, how to quantify costs of contractor failure, and avoidance techniques.

Rational Insurance Purchasing: Consideration of Contract Nonperformance

Much of the analysis of rational insurance purchasing and hedging strategies has been undertaken on the basis of the expected utility hypothesis. This decision framework has been used to reformulate the Bernoulli principle that a risk averter rationally would fully insure at a fair premium. Other applications include the analysis of insurance at unfair premiums (Mossin [1968 ] and Smith [1968]), the effects of state-dependent utility on the rational insurance purchase (Cook and Graham [1977]), the effects of risky background wealth (Doherty and Schlesinger [1983] and Mayers and Smith [1983]), and the design of the optimal insurance policy (Raviv [1979] ). Such analyses have been conducted on the assumption that insurance policies are free of insolvency (default) risk. This assumption stands in sharp contrast to the actuarial literature in which the insolvency risk, or probability of ruin, is a central focus of attention.

Regulatory structure in futures markets: Jurisdictional competition between the sec, the cftc, and other agencies

This paper studies competition among alternative regulatory bodies for authority over innovative financial contracts. In the United States, this rivalry embraces not only the Commodity Futures Trading Commission and the Securities and Exchange Commission, but state and federal deposit-institution regulators and various private regulatory cooperatives. From a political perspective, multipleregulators develop as a way of formally providing ongoing protection for the interests of diverse political constituencies. But from an economic perspective,competition resulting from overlaps in regulatory responsibility establishes an evolutionary mechanism for adapting regulatory structures to technological and regulation-induced innovation. Using both perspectives, this paper explains how interaction between governmental regulatory agencies and self-regulatory cooperatives produces more-efficient regulatory structures over time.The study also seeks to catalog the particular costs and benefits that may be associated with the regulatory tools used to control futures and securities markets(e.g., broker and trader registration, disclosure requirements, margin requirements,and contract-approval processes) and with changes in the distribution of jurisdiction over these tools. The analysis seeks to clarify the tradeoff between the perceived probability of various problems of market performance (e.g., contract nonperformance, widespread financial instability, and activities such as price manipulation by which corrupt or sophisticated operators separate naive investors from their wealth) and the implicit and explicit cost of reducing this probability.