The perverse incentive for insurance instruments that are derivatives: solving the jackpot problem with a clawback lien for default insurance notes

TL;DR

This paper identifies a perverse incentive problem in derivative-based insurance notes, like CDS, and proposes a clawback lien mechanism to align incentives and improve venture banking outcomes.

Contribution

It introduces a novel clawback lien solution to eliminate perverse incentives in default insurance notes, enhancing the effectiveness of venture capital insurance systems.

Findings

The perverse incentive reduces venture bank profitability in good investment scenarios.

Implementing a clawback lien aligns incentives and mitigates moral hazard.

The proposed mechanism improves the overall functioning of default insurance notes.

Abstract

When an insurance note is also a derivative a serious problem arises because a derivative must be fulfilled immediately. This feature of derivatives prevents claims processing procedures that screen out ineligible claims. This, in turn, creates a perverse incentive for insured holders of notes to commit acts that result in payment. This problem first surfaced with CDS contracts, which are part of a class of loan insurance I term a default insurance note. Without an address to this problem, within the average range of returns for a large venture capital portfolio, a venture-bank makes less money the better their investments do, in a continuous function. The highest rate of return is a total loss, 64% more than a top portfolio. Here, a strategy for removing this perverse incentive is defined, consisting of a clawback lien that returns part of the payment value as a lien on the firm that is the beneficiary of the insurance. This is presented as the final major component for implementing a default insurance note system so that venture-banking can operate to maximum benefit. Removing the perverse incentive also minimizes disincentive for underwriters to deny DIN coverage to new venture capital firms, or to those firms that have historical earnings which are below average.