Variance insurance contracts
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Abstract: We study the design of an optimal insurance contract in which the insured maximizes her expected utility and the insurer limits the variance of his risk exposure while maintaining the principle of indemnity and charging the premium according to the expected value principle. We derive the optimal policy semi-analytically, which is coinsurance above a deductible when the variance bound is binding. This policy automatically satisfies the incentive-compatible condition, which is crucial to rule out ex post moral hazard. We also find that the deductible is absent if and only if the contract pricing is actuarially fair. Focusing on the actuarially fair case, we carry out comparative statics on the effects of the insured's initial wealth and the variance bound on insurance demand. Our results indicate that the expected coverage is always larger for a wealthier insured, implying that the underlying insurance is a normal good, which supports certain recent empirical findings. Moreover, as the variance constraint tightens, the insured who is prudent cedes less losses, while the insurer is exposed to less tail risk.
The paper presents a scheme to derive optimal insurance contracts in which the insured maximizes her expected utility, and the insurer limits the variance of his risk exposure while maintaining the principle of indemnity and charging the premium according to the expected value principle. After presenting the main settings of the problem, including a comparison with the Pareto framework, the optimal policy is derived, satisfying the incentive-compatible condition. Then, comparative statics are dealt with, considering the effects of the insured's initial wealth and the variance constraint on insurance demand. Proofs and technical insights are in the Appendices.
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Cited in
(4)- Optimal insurance design under mean-variance preference with narrow framing
- Pareto-optimal insurance with an upper limit on the insurer's exposure
- The optimal strategy of generalized underwriting with the variance premium principle for the inclusive health insurance
- Optimal insurance design under distortion risk measures with variance constraint
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