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Dynamic optimal insurance and lack of commitment

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  • Alexander K. Karaivanov
  • Fernando M. Martin

Abstract

This paper analyzes dynamic risk-sharing contracts between profit-maximizing insurers and risk-averse agents who face idiosyncratic income uncertainty and may self-insure through savings. We study Markov-perfect insurance contracts in which neither party can commit beyond the current period. We show that the limited commitment assumption on the insurer's side is only restrictive when he is endowed with a rate of return advantage and the agent has sufficiently large initial assets. In such a case, the consumption profile is distorted relative to the first-best. In a Markov-perfect equilibrium, the agent's asset holdings determine his period outside option and are thus, an integral part of insurance contracts, unlike the case when the insurer can commit. Whether the parties can contract on the agent's savings decisions or not affects the agreement as long as the insurer makes positive profits.

Suggested Citation

  • Alexander K. Karaivanov & Fernando M. Martin, 2011. "Dynamic optimal insurance and lack of commitment," Working Papers 2011-029, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2011-029
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    References listed on IDEAS

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    Cited by:

    1. Karaivanov, Alexander K. & Martin, Fernando M., 2011. "Markov-Perfect Risk Sharing, Moral Hazard and Limited Commitment," Working Papers 2011-030, Federal Reserve Bank of St. Louis, revised 11 Sep 2017.
    2. Karaivanov, Alexander K. & Martin, Fernando M., 2016. "Market Power and Asset Contractibility in Dynamic Insurance Contracts," Review, Federal Reserve Bank of St. Louis, vol. 98(2), pages 111-127.
    3. Oikonomou, Rigas, 2013. "Optimal Unemployment Insurance with Private Insurance," MPRA Paper 55726, University Library of Munich, Germany.

    More about this item

    Keywords

    Contracts ; Risk;

    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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