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The design of an optimal insurance contract for irreplaceable commodities

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  • Rachel J. Huang

    (Department of Finance, Ming Chuan University, Taiwan, e-mail: rachel@mcu.edu.tw)

  • Larry Y. Tzeng

    (Department of Finance, National Taiwan University, Taiwan)

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. The Geneva Risk and Insurance Review (2006) 31, 11–21. doi:10.1007/s10713-006-9464-z

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Bibliographic Info

Article provided by Palgrave Macmillan 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:pal:genrir:v:31:y:2006:i:1:p:11-21

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  1. 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.
  2. 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.
  3. Louis Eeckhoudt & Olivier Mahul & John Moran, 2003. "Fixed-Reimbursement Insurance: Basic Properties and Comparative Statics," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 70(2), pages 207-218.
  4. 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.
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