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Optimal insurance under costly falsification and costly, inexact verification

  • Hau, Arthur
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    This paper integrates the often dichotomized models of costly state verification and costly claim falsification. It is found that when verification is inexact, it is possible for an optimal insurance contract to consist of both positive claim falsification and positive insurer verification, provided that falsification cost and verification cost are sufficiently low, and the insured is risk-averse satisfying constant absolute risk aversion. This result certainly contrasts with the common belief that falsification and verification are mutually exclusive in an optimal insurance contract. Some characteristics of the optimal falsification, verification, and indemnification profiles, including implementability, are analyzed.

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    File URL: http://www.sciencedirect.com/science/article/B6V85-4P6VD30-1/1/cd2608d9f2c98917ee3a47f62fa13ba6
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    Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

    Volume (Year): 32 (2008)
    Issue (Month): 5 (May)
    Pages: 1680-1700

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    Handle: RePEc:eee:dyncon:v:32:y:2008:i:5:p:1680-1700
    Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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    1. Marie-Cécile Fagart & Pierre Picard, 1999. "Optimal Insurance Under Random Auditing," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 24(1), pages 29-54, June.
    2. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
    3. Picard, Pierre, 1996. "On the design of optimal insurance policies under manipulation of audit cost," CEPREMAP Working Papers (Couverture Orange) 9605, CEPREMAP.
    4. Giovanni Maggi & Andres Rodriguez-Clare, 1995. "Costly Distortion of Information in Agency Problems," RAND Journal of Economics, The RAND Corporation, vol. 26(4), pages 675-689, Winter.
    5. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, June.
    6. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
    7. Picard, Pierre, 1996. "Auditing claims in the insurance market with fraud: The credibility issue," Journal of Public Economics, Elsevier, vol. 63(1), pages 27-56, December.
    8. Bond, Eric W. & Crocker, Keith J., 1997. "Hardball and the soft touch: The economics of optimal insurance contracts with costly state verification and endogenous monitoring costs," Journal of Public Economics, Elsevier, vol. 63(2), pages 239-264, January.
    9. Louis Kaplow, 1993. "Optimal Insurance Contracts When Establishing The Amount of Losses is Costly," NBER Working Papers 4290, National Bureau of Economic Research, Inc.
    10. Roger B. Myerson, 1977. "Incentive Compatability and the Bargaining Problem," Discussion Papers 284, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    11. repec:cup:cbooks:9780521337465 is not listed on IDEAS
    12. Lacker, Jeffrey M & Weinberg, John A, 1989. "Optimal Contracts under Costly State Falsification," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1345-63, December.
    13. Keith J. Crocker & John Morgan, 1998. "Is Honesty the Best Policy? Curtailing Insurance Fraud through Optimal Incentive Contracts," Journal of Political Economy, University of Chicago Press, vol. 106(2), pages 355-375, April.
    14. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
    15. repec:cup:cbooks:9780521331586 is not listed on IDEAS
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