SFB 303 Discussion Paper No. A - 342

Author: Peters, Wolfgang
Title: Using Right Incentives when Cheating Can Be Detected. The Case of Disability Insurance
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, since inability to work has a great impact on the potential income flow. Hence, these individuals will, through an insurance institution, attempt to reduce the disability risk. There always will be an incentive to found an insurance agency, since the demand for security is given; and every individual demand gives rise to an adequate supply. 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 what we want to analyze; it can be found in the literature under the heading "incentive compatibility". The insurance institution offers such a contract that nobody has an incentive to lie to the insurance institution or to commit "insurance fraud". Even in the case where a test enables the insurance to monitor the actual status of health the phenomenon of moral hazard does not vanish if the test is not faultless and costless at the same time. If cheating the insurance can be detected a punishment constitutes a potential threat. In such an environment the question arises: Should an insurance supply more monetary incentives through premiums and benefits or is a sophisticated test the right instrument to enforce incentive compatibility. The aim of the present study is to introduce monitoring which provides a screening possibility to the insurance. Our main concern then is to analyze the additional effects which occur when extending the usual principal-agent approach to applying a health test.
Creation-Date: July 1991
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