SFB 303 Discussion Paper No. A - 158

Author: Peters, Wolfgang
Title: Risk, Incentives, and Insurance: The Case of Disability
Abstract: If all agents in an economy are affected by the same risk factor, the risk can be reduced by insurance. This is especially important in the case of disability risk, since inability to work has a great effect on the potential income flow. As with every kind of insurance, moral hazard must be taken into account when designing an insurance contract in which it is impossible to verify the person's actual disability. This is precisely the case we want to analyse; it can be found in the literature under the heading "incentive compatibility", which already says something about the planning methodology. The insurance institution offers such a contract that nobody has an incentive to lie the insurance institution or to commit "insurance fraud".The aim of the present study is to describe an insurance contract covering the disability risk. Moreover, the insurance contract should, at the same time, serve another function as well: if the contract offers the market interest rate on premiums paid, it enables capital formation and intertemporal income transfer. Thus savings can be accumulated to finance the consumption during the retirement age or in the disability phase. Through personal savings, individuals have the opportunity to take their own steps to ensure a secure income flow for the future. If we assume a competitive insurance market, a contract can only be feasible on a long-term basis if it maximizes the individualsī lifetime utility. This optimum contract will be described and discussed here. The insurance can be organized privately or publicly, since, given perfect competition, the kind of organization has no influence on the type or extent of the contract. The market forces imply a contract, which is the best one possible and incentive compatible at the same time.
Creation-Date: 1988
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