Moral Hazard In Dynamic Insurance Classification Risk And Prepayment

This paper examines the effect of moral hazard on dynamic insurance contract. It models primary prevention in a two period model with classification risk. Agents' preferences appear to play an important role in the determination of preventive effort and prepayment. If absolute prudence is larger that absolute risk aversion, moral hazard increases prepayment of premium and classification risk. This highlights a tradeoff between prevention and prepayment that arises from the classification risk. An increase in the difference between prudence and twice risk aversion (that we define as the degree of foresight) moreover makes dynamic insurance contracts more stable (when competing with spot insurance) if the cost of prevention is low enough when agents preferences exhibit CRRA. Under a formulated utility function with linear reciprocal derivative, we finally show that an increase in agents' degree of foresight enhances the stability of dynamic contract and the extent of prepayment.