WP 2015-02 Optimal Insurance Contracts with Insurer’s Background Risk
ABSTRACT: Existing research on insurance contract theory emphasizes information problems and demand side issues when explaining contract structure. Supply-side factors, especially risk considerations at the insurer, have received much less attention. In this paper, we extend the optimal contracting framework of Raviv (1979) to explore how background risk at the insurer affects optimal contract structure. We confirm earlier findings that insurer background risk may reduce risk sharing in the optimal contract. We go further to show that positive correlation between the insurer’s background risk and the insured’s loss can yield contract forms ruled out by the standard model, such as upper limits on coverage, and explain patterns of risk sharing not addressed in the literature, such as large deductibles in catastrophe contracts.