Insurance design and arson-type risks

TL;DR

This paper develops a framework for designing manipulation-proof insurance contracts in the presence of arson-type risks, showing how such risks influence contract features and insured welfare.

Contribution

It introduces a novel manipulation-proof contract design incorporating deductibles, coinsurance, and upper limits under arson-type risks.

Findings

Optimal contracts are continuous with bounded slope and no-sabotage conditions.

Contracts with deductibles, coinsurance, and upper limits are manipulation-proof.

Arson-type risks decrease insured welfare by reducing coverage in equilibrium.

Abstract

We design the insurance contract when the insurer faces arson-type risks. The optimal contract must be manipulation-proof. It is therefore continuous, it has a bounded slope, and it satisfies the no-sabotage condition when arson-type actions are free. Any contract that mixes a deductible, coinsurance and an upper limit is manipulation-proof. We also show that the ability to perform arson-type actions reduces the insured's welfare as less coverage is offered in equilibrium.