Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Knut K. Aase
Pareto Optimal Insurance Policies in the Presence of Administrative Costs
Abstract: In his classical article in The American Economic Review,
Arthur Raviv (1979) examines Pareto optimal insurance contracts when there
are ex-post insurance costs c induced by the indemnity I for loss x.
Ravivís main result is that a necessary and sufficient condition for the
Pareto optimal deductible to be equal to zero is c'(I) = 0 for all I >= 0.
We claim that another type of cost function is called for in household
insurance, caused by frequent but relatively small claims. If a fixed cost
is incurred each time a claim is made, we obtain a non-trivial Pareto
optimal deductible even if the cost function does not vary with the
indemnity. This implies that when the claims are relatively small, it is
not optimal for the insured to get a compensation since the costs outweighs
the benefits, and a deductible will naturally occur. We also discuss
policies with an upper limit, and show that the insurer prefers such
contracts, but the insured does not. In Ravivís paper it was also shown
that policies with upper limits are dominated by policies with no upper
limit, when there are ex-post costs to insurance. We show that the result
is right, but the proof is wrong.
Keywords: Pareto optimal risk sharing; administrative costs in insurance; household insurance; XL-contracts; (follow links to similar papers)
JEL-Codes: G22; (follow links to similar papers)
16 pages, August 31, 2010
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