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Saturday, April 1, 2006

Umbrella Policies and Multiple Moral Hazard

Few areas of contract law require so much complex drafting as insurance.  Designing insurance policies is difficult enough when the event is beyond the insured's control.  But when the insured has some substantial control over whether the payout occurs -- as by deliberately engaging in risky conduct or ignoring safety precautions ("moral hazard") -- the problem gets worse.  In a new article, Multiple Losses, Ex Ante Moral Hazard, and the Implications for Umbrella Policies, forthcoming in the Journal of Risk and Insurance, Michael Breuer of the Socioeconomic Institute at the University of Zurich looks at the issues involved in classic umbrella policies.

Under certain cost conditions the optimal insurance policy offers full coverage above a deductible, as Arrow and others have shown. However, many insurance policies currently provide coverage against several losses although the possibilities for the insured to affect the loss probabilities by several prevention activities (multiple moral hazard) are substantially different. This article shows that optimal contracts under multiple moral hazard generally call for complex reimbursement schedules. It also examines the conditions under which different types of risks can optimally be covered by a single insurance policy and argues that the case for umbrella policies under multiple moral hazard is limited in practice.

[Frank Snyder]

http://lawprofessors.typepad.com/contractsprof_blog/2006/04/umbrella_polici.html

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