Pooling and Separating Equilibria in Insurance Markets with Adverse Selection and Distribution Costs

In the Rothschild-Stiglitz [1976] model of a competitive insurance market with adverse selection, pooling equilibria cannot exist. However in practice, pooling contracts are frequent, notably in health insurance and life insurance. This is due to the fact that distribution costs are nonnegligible and increase rapidly when more contracts are offered. We modify accordingly the Rothschild-Stiglitz model by introducing such distribution costs. We find that, however small these costs may be, they entail possible existence of pooling equilibria. Moreover, in these pooling equilibria, it is the high-risk individuals who are rationed, in the sense that they would be willing to buy more insurance at the current premium/insurance ratio.     

Asymmetric Information, Long-Term Care Insurance, and Annuities: The Case for Bundled Contracts

This article examines the markets for long-term care insurance and annuities when there is asymmetric information and there are costs of administering contracts. Individuals differ in terms of their risk aversion. Risk-averse individuals take more care of their health and are relatively high risk in the annuities market and relatively low risk in the long-term care insurance market. In the long-term care insurance market, both separating and partial-pooling equilibria are possible. However, in the stand-alone annuity market, only separating equilibria are possible. We show, consistent with the extant empirical research, that in the presence of administration costs the more risk-averse individuals may buy relatively more long-term care insurance and more annuity coverage. Under the same assumptions, we show that equilibria exist with bundled contracts that Pareto dominate the outcomes with stand-alone contracts and are robust to competition from stand-alone contracts. The remaining empirical puzzle is to explain why bundled contracts are such a small share of the voluntary annuity market.     

Arbitrage and Viability in Insurance Markets

Insurance markets are subject to transaction costs and constraints on portfolio holdings. Therefore, unlike the frictionless asset markets case, viability is not equivalent to absence of arbitrage possibilities. We use the concept of unbounded arbitrage to characterize viable prices on a complete and an incomplete insurance market. In the complete market, there is an insurance contract for every possible event. In the incomplete market, risk can be insured through proportional and excess of loss like insurance contracts. We show how the the structure of viable prices is affected by the portfolio constraints, the transaction costs, and the structure of marketed contracts.     

Hidden insurance in a moral‐hazard economy

We analyze the general equilibrium of an economy in which a competitive industry produces nonexclusive insurance services. The equilibrium is inefficient because insurance contracts cannot control moral hazard, and welfare can be improved by policies that reduce insurance by increasing its price above marginal cost. We discuss how insurance production costs that exceed expected claim payments interact with moral hazard in determining the equilibrium's inefficiency, and show that these costs can make insurance premia so actuarially unfair as to validate the standard first‐order conditions we exploit in our analysis.     

Systemlücken im deutschen und europäischen Haftungs- und Schadensrecht

The european liability systems differ widely. The divergences arise in the liability systems themselves, the extent of compensation in relation to damaged property and personal injury claims and the costs of bringing about an action. It is particulary problematic that the person having suffered damages (could say: injured party) cannot insure an unforeseen event and in addition the (tortfeasor) wrongdoer will often have to bear the costs for his own damages.The essay develops a concept of compensation that aims to close the liability gaps through private insurance contracts. In the context of these insurance contracts it is possible to choose the preferred legal system. The european liability and compensation systems can be harmonized without straining the european legislator. Furthermore, the article goes on to show that class action is going to gain more importance in Europe.     

Natural Disaster Insurance and the Equity-Efficiency Trade-Off

This article investigates the role of private insurance in the prevention and mitigation of natural disasters. We characterize the equity‐efficiency trade‐off faced by the policymakers under imperfect information about individual prevention costs. It is shown that a competitive insurance market with actuarial rate making and compensatory tax‐subsidy transfers is likely to dominate regulated uniform insurance pricing rules or state‐funded assistance schemes. The model illustrates how targeted tax cuts on insurance contracts can improve the incentives to prevention while compensating individuals with high prevention costs. The article highlights the complementarity between individual incentives through tax cuts and collective incentives through grants to the local jurisdictions where risk management plans are enforced.     

Why haven’t U.S. GAAP and IFRS on insurance contracts converged? Evidence from an unsuccessful joint project

This study examines the FASB’s and IASB’s unsuccessful joint project on accounting for insurance contracts. It highlights the divergent views the Boards may hold on certain fundamental accounting issues. Further, this study examines how the costs and benefits of accounting standard convergence can vary within an industry, conditional on factors such as prior accounting standards and firms’ global operations. Empirically, U.S. insurers’ negative market reactions to the joint insurance project suggest U.S. investors perceived net costs would outweigh net benefits. This study also finds that market reactions of U.S. insurers were more negative than those of European insurers. The results of cross-sectional analyses indicate that U.S. life insurers perceived higher net costs associated with the joint project, while European insurers with more global revenue perceived higher net benefits. This work illuminates some of the challenges facing standard setters when attempting to develop a globally acceptable set of financial reporting standards.     

Capital Allocation for Insurance Companies—What Good IS IT?

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A. Read Jr. propose to use a specific capital allocation method for pricing insurance contracts. We show that in their model framework no capital allocation to lines of business is needed for pricing insurance contracts. In the case of having to cover frictional costs, the suggested allocation method may even lead to inappropriate insurance prices. Beside the purpose of pricing insurance contracts, capital allocation methods proposed in the literature and used in insurance practice are typically intended to help derive capital budgeting decisions in insurance companies, such as expanding or contracting lines of business. We also show that net present value analyses provide better capital budgeting decisions than capital allocation in general.     

Suspension of Convertibility versus Deposit Insurance: A Welfare Comparison

This paper introduces risk-averse preferences in Chariand Jagannathan (1988). A first motivation for thisextension is to give a positive role for a financial intermediaryin the economy, who offers risk-sharing contracts to liquidityseeking individuals. In this framework, both information-inducedan pure panic runs will occur. The second motivation is tocomplete Chari and Jagannathan's welfare analysis by comparingsuspension of convertibility and deposit insurance, given theirrelative benefits and costs (of randomization in meeting liquidityneeds or deadweight taxation). It is shown that the choice betweenthe two contracts depends on the level of risk aversion, theintertemporal discount factor and the attributes about theunderlying technology.     

Der neue Standard zur bilanziellen Abbildung von Versicherungsverträgen (IFRS 17) – Eine kritische Analyse der Auswirkungen auf die Versicherungsbranche

The new standard for the accounting of insurance contracts (IFRS 17) will entail substantial changes for the insurance industry. In the following article the new standard is critically analyzed. First and foremost the coming valuation model, the so-called building block approach, is presented which will be the basis for all insurance contracts within the scope of IFRS 17. (For certain insurance contracts, especially those with direct participation features, or for less complex or short-term insurance contracts, there are some modifications.) To be more precise, IFRS 17 introduces an enterprise-specific valuation approach that is grounded on the so-called fulfilment value. This fulfilment value is determined by four separate building blocks (fulfilment-cashflow, discount rate, risk margin and contractual service margin), which will be addressed in detail. Finally, major changes in performed accounting practices that insurance enterprises are confronted with and will have to adapt to in their financial statements and accounts are pointed out.     

Efficiency in the international insurance industry: A cross-country comparison

The purpose of this paper is to provide new empirical evidence on frontier efficiency measurement in the international insurance industry, a topic of great interest in the academic literature during the last several years. A broad efficiency comparison of 6462 insurers from 36 countries is conducted. Different methodologies, countries, organizational forms, and company sizes are compared, considering life and non-life insurers. We find a steady technical and cost efficiency growth in international insurance markets from 2002 to 2006, with large differences across countries. Denmark and Japan have the highest average efficiency, whereas the Philippines is the least efficient. Regarding organizational form, the results are not consistent with the expense preference hypothesis, which claims that mutuals should be less efficient than stocks due to higher agency costs. Only minor variations are found when comparing different frontier efficiency methodologies (data envelopment analysis, stochastic frontier analysis).     

VOLUNTARY DISCLOSURE BY FINANCIAL INTERMEDIARIES: EVIDENCE FROM AUSTRALIAN LIFE INSURERS PROMOTING INVESTMENT-RELATED CONTRACTS

Voluntary financial disclosure by Australian life insurers promoting investment-related contracts is predicted to be related to fees, funds under management, investment risk and return, liability risk and marketing costs factors. The decision to voluntarily disclose various forms of financial data in documents promoting investment-related contracts was studied during 1989-90. Life insurance managers providing financial disclosures tend to: (a) charge lower fees, (b) hold larger funds under management, (c) are exposed to higher investment risk, (d) are exposed to lower liability risk and (e) bear lower marketing costs. This evidence supports Mayers and Smiths' [1981] positive theory of insurance-related contracting.     

Insurance Contract Design When the Insurer Has Private Information on Loss Size

This article examines the optimal indemnity contract in an insurance market, when the insurer has private information about the size of an insurable loss. Both parties know whether or not a loss occurred, but only the insurer knows the true value of the loss and/or to what extent the losses are covered under the policy. The insured may verify the insurer's loss estimate for a fixed auditing cost. The optimal contract reimburses the auditing costs in addition to full insurance for losses less than some endogenous limit. For losses exceeding this limit, the contract pays a fixed indemnity and requires no monitoring. The optimal contract is compared with the contracts obtained in cases where it is only the insured who can observe the loss size.
     

Contracting on litigation

Two risk‐averse litigants with different subjective beliefs negotiate in the shadow of a pending trial. Through contingent contracts, the litigants can mitigate risk and/or speculate on the trial outcome. Contingent contracting decreases the settlement rate and increases the volume and costs of litigation. These contingent contracts mimic the services provided by third‐party investors, including litigation funders and insurance companies. The litigants (weakly) prefer to contract with risk‐neutral third parties when the capital market is transaction‐cost free. However, contracting with third parties further decreases the settlement rate, increases the costs of litigation, and may increase the aggregate cost of risk bearing.     

Der Exposure Draft „Insurance Contracts“ – Eine kritische Analyse aus theoretischer Sicht

The Exposure Draft “Insurance Contracts”, issued by the International Accounting Standards Board (IASB) in July 2010, contains the IASB’s latest proposals regarding accounting on insurance contracts by insurance enterprises and is the basis for the planned International Financial Reporting Standard “Insurance Contracts” which shall be finished in 2011. The paper follows a presentation with the same title at the Annual Congress of the German Insurance Science Association in Berlin on March 17th, 2011 and mainly aims at a comparison of the IASB’s proposals with the solutions derived from different accounting theories for the most important accounting problems concerning insurance contracts, namely the treatment of premiums, losses, and acquisition costs. The IASB’s proposals do not follow one of these theories homogeneously and contain several additional inconsistencies. Irrespective of their pros and cons in the light of other criteria they, therefore, have to be criticized as highly problematic.     

Gestaltungsformen der Bilanzierung von Versicherungsverträgen: ein kritischer Vergleich von Deferral / Matching- und Asset / Liability-Ansätzen

On 31 of March 2004 the IASB issued the IFRS 4 (Insurance Contracts), which is a stepping stone to the second phase of its project on insurance contracts. The new standard deals with limited improvements to accounting practices for insurance contracts, without requiring major changes that may need to be revised in phase II. In the second phase of the project a recognition and measurement model is expected to be finalised which differs significantly from the traditional approach to accounting for insurance contracts. It will be an asset / liability-approach that requires an entity to identify and measure directly the rights and obligations arising from insurance contracts. The resulting assets and liabilities should be measured at their fair value. In contrast to the asset / liability-approach, the traditional approach to accounting for insurance contracts, referred to as deferral / mat-ching-approach, emphasises the measurement of income. Both approaches and their corresponding implications on the balance sheet and the profit and loss statement are analysed in detail.     

Zur bedeutung einer Ausfallbedrohtheit von Versicherungskontrakten — ein Beitrag zur Behavioral Insurance

Kahneman / Tversky 1979 introduced the notion of so-called probabilistic insurance contracts. These are insurance policies involving a small probability that the consumer is not reimbursed because of a possible default of the insurance company. Extending the study ofWakker / Thaler / Tversky 1997, the present study contains an experimental analysis of the willingness of potential policyholders to pay for probabilistic insurance in dependency on the rating of the insurance company. It can be shown that people dislike probabilistic insurance and demand a substantial reduction in the premium to compensate for default risk. This reduction is rising with the default risk of the company. In addition, the results show a new phenomenon. The more an insurance company is threatened by default risk the less people are willing to accept contracts of this company at all. Finally the paper discusses implications for the control of insurance companies.     

Bargaining Power and Efficiency in Insurance Contracts

Insurance contracts are frequently modelled as principal–agent relationships. The purpose of this paper is to examine the interaction between differential bargaining power and the efficiency of insurance contracts. The analysis is undertaken in a framework of state-contingent production, which allows us to consider, as separate choices, the level of effort committed by the client and the riskiness of the equilibrium state-contingent production vector. Our central result is that, in the presence of hold-up problems, the exercise of monopoly power by insurers leads clients to undertake socially costly self-protection, leading to suboptimal levels of insurance. Clients can exploit information asymmetries to offset the bargaining power of the insurer, but this process is also socially costly. Hence, competitive markets for insurance will yield a Pareto-superior outcome to the constrained Pareto-optimum reached in markets where insurers have monopoly power. More generally, in a bargaining situation, an increase in the bargaining power of clients will increase social welfare.     

Mossin's Theorem for Upper-Limit Insurance Policies

Although Mossin's Theorem (“full insurance with a fair premium and less‐than‐full coverage with a proportional premium loading”) is well known for the classes of coinsurance contracts and for deductible‐insurance contracts, it has not been proven for the class of upper‐limit insurance contracts. This article provides a proof for this case.     

Competitive risk sharing contracts with one-sided commitment

This paper analyzes dynamic equilibrium risk sharing contracts between profit-maximizing intermediaries and a large pool of ex ante identical agents that face idiosyncratic income uncertainty that makes them heterogeneous ex post. In any given period, after having observed her income, the agent can walk away from the contract, while the intermediary cannot, i.e. there is one-sided commitment. We consider the extreme scenario that the agents face no costs to walking away, and can sign up with any competing intermediary without any reputational losses. We demonstrate that not only autarky, but also partial and full insurance can obtain, depending on the relative patience of agents and financial intermediaries. Insurance can be provided because in an equilibrium contract an up-front payment effectively locks in the agent with an intermediary. We then show that our contract economy is equivalent to a consumption-savings economy with one-period Arrow securities and a short-sale constraint, similar to Bulow and Rogoff [1989. Sovereign debt: is to forgive to forget? American Economic Review 79, 43-50]. From this equivalence and our characterization of dynamic contracts it immediately follows that without cost of switching financial intermediaries debt contracts are not sustainable, even though a risk allocation superior to autarky can be achieved.