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Optimal long-term contracts with disability insurance under limited commitment

Author

Listed:
  • Choi, Kyoung Jin
  • Jeon, Junkee
  • Lee, Ho-Seok
  • Lin, Hsuan-Chih

Abstract

We study an optimal long-term labor contract that provides disability insurance benefits under two frictions: the agent cannot commit to a long-term contract and the disability shock is private information. We predict that a job with a high risk of disability should provide a higher level of salary but with a lower growth rate over time. We find that the optimal contract can be implemented under a three-account trading system in which mandatory savings can be imposed to discourage a worker from falsely claiming disability. We also investigate how the nature of disability shock has an impact on the optimal contract: a larger borrowing limit should be given to a worker with a high severity of the disability shock or a low arrival intensity. Finally, our quantitative analysis shows that the cost caused by current long-term disability insurance practice can be substantial.

Suggested Citation

  • Choi, Kyoung Jin & Jeon, Junkee & Lee, Ho-Seok & Lin, Hsuan-Chih, 2022. "Optimal long-term contracts with disability insurance under limited commitment," Insurance: Mathematics and Economics, Elsevier, vol. 104(C), pages 99-132.
    • Handle: RePEc:eee:insuma:v:104:y:2022:i:c:p:99-132
    DOI: 10.1016/j.insmatheco.2022.02.007
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    More about this item

    Keywords

    Disability insurance; Limited commitment; Truth-telling; Dynamic contracting; Incentives;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • I13 - Health, Education, and Welfare - - Health - - - Health Insurance, Public and Private

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