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Dynamic Optimal Insurance and Lack of Commitment

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  • Fernando M. Martin

    (Simon Fraser University)

  • Alexander Karaivanov

    (Simon Fraser University)

Abstract

We analyze the role of commitment in a dynamic principal-agent model of optimal insurance with hidden effort and observable but non-contractible assets. We argue that the optimal contract under full commitment is time-inconsistent. Consequently, we solve for and analyze the optimal insurance contract when both the agent and the principal cannot commit (i.e., each can renege in each period) and contrast our results with the full commitment case studied by the existing literature. We find that the Markov-perfect contract under double-sided lack of commitment provides additional insurance relative to the self-insurance allocation and features a non-degenerate long-run asset and consumption distributions. Furthermore, the no commitment contract differs significantly from the full commitment contract in the time profiles of consumption and savings, insurance, and welfare. We solve numerically for the optimal insurance contract in several environments characterized by different degrees of market imperfections. We find that the welfare loss due to lack of commitment is very high relative to the welfare costs of moral hazard or savings non-contractibility.

Suggested Citation

  • Fernando M. Martin & Alexander Karaivanov, 2007. "Dynamic Optimal Insurance and Lack of Commitment," 2007 Meeting Papers 793, Society for Economic Dynamics.
    • Handle: RePEc:red:sed007:793
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    Cited by:

    1. Karaivanov, Alexander K. & Martin, Fernando M., 2018. "Markov-perfect risk sharing, moral hazard and limited commitment," Journal of Economic Dynamics and Control, Elsevier, vol. 94(C), pages 1-23.
    2. Oikonomou Rigas, 2018. "Unemployment insurance with limited commitment wage contracts and savings," The B.E. Journal of Macroeconomics, De Gruyter, vol. 18(1), pages 1-21, January.
    3. Alexander K. Karaivanov & Fernando M. Martin, 2016. "Market Power and Asset Contractibility in Dynamic Insurance Contracts," Review, Federal Reserve Bank of St. Louis, vol. 98(2).
    4. Yanyan Liu & Robert J. Myers, 2016. "The Dynamics Of Microinsurance Demand In Developing Countries Under Liquidity Constraints And Insurer Default Risk," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 83(1), pages 121-138, January.
    5. Oikonomou, Rigas, 2013. "Optimal Unemployment Insurance with Private Insurance," MPRA Paper 55726, University Library of Munich, Germany.
    6. Alexander Karaivanov, 2021. "Blockchains, Collateral and Financial Contracts," Discussion Papers dp21-03, Department of Economics, Simon Fraser University.
    7. Nguyen Phuc Canh & Udomsak Wongchoti & Su Dinh Thanh, 2021. "Does economic policy uncertainty matter for insurance development? Evidence from 16 OECD countries," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 46(4), pages 614-648, October.

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    More about this item

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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