A Compound Option Model to Value Moral Hazard

Abstract

Introduction and adoption of new derivative structures can be greatly influenced by government regulation at several levels. The insurance industry in the U.S., for example, faces stringent regulation at the state level, such that use of derivatives for risk management has at times been significantly impeded. Hedging transactions involving derivatives, and some income generation strategies are now generally accepted for insurance companies. But a “new” strategy for insurers, which essentially amounts to a type of arbitrage, has only recently been cleared for use. The transactions are known as “Replication (Synthetic Asset) Transactions” (RSATs). An RSAT amounts to a standard derivatives arbitrage portfolio, in which a position is constructed that mimics the payoff of some other instrument. Claims on the synthetic instrument are then sold in the market, supported by the replicating portfolio. In this article, Driscoll explains the newly adopted regulatory framework that governs how such transactions will be handled in the insurance industry.