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The design of an optimal insurance contract for irreplaceable commodities

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  • Rachel Huang

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  • Larry Tzeng

Abstract

This paper discusses optimal insurance contract for irreplaceable commodities. To describe the dual impacts on individuals when a loss occurs to the insured irreplaceable commodities, we use a state-dependent and bivariate utility function, which includes both the monetary wealth and sentimental value as two arguments. We show that over (full, partial) insurance is optimal when a decrease in sentimental value will increase (not change, decrease, respectively) the marginal utility of monetary wealth. Moreover, a non-zero deductible exists even without administration costs. Furthermore, we demonstrate that a positive fixed reimbursement is optimal if (1) the premium is actuarially fair, (2) the monetary loss is a constant, and (3) the utility function is additively separable and the marginal utility of money is higher in the loss state than in the no-loss state. We also characterize comparative statics of fixed-reimbursement insurance under an additively separable preference assumption. Copyright Springer Science + Business Media, LLC 2006

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File URL: http://hdl.handle.net/10.1007/s10713-006-9464-z
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Bibliographic Info

Article provided by Springer in its journal THE GENEVA RISK AND INSURANCE REVIEW.

Volume (Year): 31 (2006)
Issue (Month): 1 (July)
Pages: 11-21

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Handle: RePEc:kap:geneva:v:31:y:2006:i:1:p:11-21

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Web page: http://www.springerlink.com/link.asp?id=102897

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Keywords: Deductible; Optimal insurance contract; Fixed-reimbursement insurance; Irreplaceable commodities;

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  1. EECKHOUDT, Louis & MAHUL, Olivier & MORAN, John, . "Fixed-reimbursement insurance: basic properties and comparative statics," CORE Discussion Papers RP -1619, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  2. Diamond, Peter A. & Stiglitz, Joseph E., 1974. "Increases in risk and in risk aversion," Journal of Economic Theory, Elsevier, vol. 8(3), pages 337-360, July.
  3. Cook, Philip J & Graham, Daniel A, 1977. "The Demand for Insurance and Protection: The Case of Irreplaceable Commodities," The Quarterly Journal of Economics, MIT Press, vol. 91(1), pages 143-56, February.
  4. Diewert, W. E. & Wales, T. J., 1995. "Flexible functional forms and tests of homogeneous separability," Journal of Econometrics, Elsevier, vol. 67(2), pages 259-302, June.
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