additional aspects of rational insurance purchasing the purchase of insurance provides an individual with the ability to shift risk associated with either timeless or temporal uncertain prospects see dreze and modigliani 1972 previous insurance decision analysis can be further divided into cases in which the insurance contract is exogenously specified see mossin 1968 smith 1968 and cases in which the optimal form of contract is to be determined see raviv 1979 brennan and solanki 1981 this note is concerned with extending some of the results for timeless uncertain prospects with the insurance contract exogenously specified many of the properties associated with the purchase of insurance for timeless uncertain prospects are analyzed by mossin 1968 for different forms of contracts see also gould 1969 utilizing the arrow pratt measure of absolute risk aversion the effect of wealth upon the optimal amount of insurance is determined for the different forms of contracts recent work by ross 1981 demonstrates that in situations where individuals face more than one timeless uncertain prospect and they can purchase insurance only for a subset of these prospects then a more risk averse individual in the arrow pratt this paper examines the use of the arrowpratt and ross measures of risk aversion it is shown that in situations where the individual faces more than one uncertain prospect and can purchase insurance only for a subset of these prospects then in many cases the arrow pratt and ross measures of risk aversion are not sufficient to describe the behavior of the individual in purchasing insurance

optimal insurance design with random initial wealth abstract an optimal insurance policy is designed when the policyholder faces both insurable and uninsurable risks under a realistic behavioral assumption it may display a disappearing deductible if the uninsurable loss becomes riskier according to any degree of stochastic dominance as the insurable loss increases

optimal insurance in incomplete markets this paper examines the theory of optimal insurance purchasing in the presence of uninsurable background risk existing theorems concerning the optimal level of insurance and the optimal form of an insurance contract are shown to hold only under restricted market and risk assumptions in particular conditions sufficient for the optimality of full coverage or sufficient for the optimality of deductible policies depend on the correlation between insurable and uninsurable risks these results may provide a partial explanation why existing theory is often contradicted by observable behavior

constrained efficient contracts for area yield crop insurance with area yield crop insurance indemnification occurs when area yield falls below a yield trigger that is chosen by the producer the maximum value for this yield trigger is generally restricted e g 80 of the long term area average yield the impact of this trigger constraint on the optimal design of an area yield insurance contract is examined within the constrained efficient contract indemnities consist of both a lump sum payment and a payment that is proportional to the yield shortfall because lump sum payments may not be feasible to implement efficiency enhancing modifications to standard contracts are also proposed copyright 2000 oxford university press

lotteries insurance and star shaped utility functions abstract most agents insure against risks which entail large losses but few insure against small losses the fact that organized lotteries charge low ticket prices examplifies this spirit this weakly risk averse behavior pattern seems to be well structured but is at variance with concavity we derive axiomatically a class of utility functions star shaped which accommodate these phenomena concavity yields risk aversion everywhere and decreasing marginal utility star shaped utility functions exhibit risk aversion at some wealth positions and average utility from any of these is a decreasing function of wealth

optimum area yield crop insurance cet article determine le contrat optimal d assurance dont l indemnite depend du rendement agrege sur recoltes d un bassin de production le schema optimal d assurance est base sur le coefficient individuel de regression qui mesure la sensibilite du rendement agrege a des variations du rendement agrege une indemnite est versee lorsque le rendement agrege est inferieur superieur a un rendement critique si le coefficient de regression est positif negatif le contrat optimal contient une franchise evanescente si le coefficient de regression est superieur a l unite

optimal risk sharing with background risk this paper examines qualitative properties of efficient insurance contracts in the presence of background risk in order to get results for all strictly risk averse expected utility maximizers the concept of stochastic increasingness is used different assumptions on the stochastic dependence between the insurable and uninsurable risk lead to different qualitative properties of the efficient contracts the new results obtained under hypotheses of dependent risks are compared to classical results in the absence of background risk or to the case of independent risks the theory is further generalized to nonexpected utility maximizers

optimal coverage for incompletely reliable insurance abstract optimal actuarially fair coverage of insurance subject to default risk can be less or more than full depending upon the relation between the recovery rate under default and a positive trigger level that is independent of the insured s risk preference

insurance with multiple insurers a game theoretic approach this paper studies the set of pareto optimal insurance contracts and the core of an insurance game our setting allows multiple insurers with translation invariant preferences we characterise the pareto optimal contracts which determines the shape of the indemnities closed form and numerical solutions are found for various preferences that the insurance players might have determining associated premiums with any given optimal pareto contract is another problem for which economic based arguments are further discussed we also explain how one may link the recent fast growing literature on risk based optimality criteria to the pareto optimality criterion and we show that the latter is much more general than the former one which according to our knowledge has not been pointed out by now further we extend some of our results when model risk is included i e there is some uncertainty with the risk model and or the insurance players make decisions based on divergent beliefs about the underlying risk these robust optimal contracts are investigated and we show how one may find robust and pareto efficient contracts which is a key decision making problem under uncertainty

contract nonperformance risk and uncertainty in insurance markets insurance contracts may fail to perform leading to a default on valid claims we relax the standard assumption of known probabilities for such defaults by allowing for uncertainty within a large behavioral experiment we show that introducing risk and uncertainty each leads to significant reductions in insurance demand and that the effects are comparable in magnitude 17 1 and 14 5 percentage points furthermore risk and ambiguity averse participants are affected most these findings are in line with models incorporating ambiguity attitudes or alternatively pessimistic beliefs an analysis of the belief and decision dynamics suggests persistent pessimistic priors and disregard of peer experiences leading to a stable uncertainty effect

the interdependence of individual portfolio decisions and the demand for insurance we analyze the individual s demand for insurance as a special case of general portfolio hedging activity the demand for insurance contracts is determined simultaneously with the demands for other assets in the portfolio we demonstrate that when the payoffs of the policy are correlated with the payoffs to the individual s other assets the demand for insurance contracts is generally not a separable portfolio decision we argue that this separability condition is not generally met because of significant interdependence of claims across different insurance policies furthermore our generalizations can reverse the standard prediction that wealthier individuals will demand less insurance

cross hedging under multiplicative basis risk cross hedging price risk in an incomplete financial market creates basis risk we propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way under this specification positive prudence is a necessary and sufficient condition for underhedging in an unbiased market using the example of cross hedging jet fuel price risk with crude oil futures we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model

firm specific assets and the link between exchange rates and foreign direct investment foreign direct investment fdi theory and empirical studies have generated mixed support for a link between exchange rates and fdi this paper argues that exchange rate movements may affect acquisition fdi because acquisitions involve firm specific assets which can generate returns in currencies other than that used for purchase using data on japanese acquisitions in the united states across three digit sic industries from 1975 to 1992 maximum likelihood estimates from discrete dependent variable models support the hypothesis that real dollar depreciations make japanese acquisitions more likely in u s industries particularly those which more likely have firm specific assets copyright 1997 by american economic association

optimal insurance design under narrow framing abstract in this paper we study insurance decisions when the policyholder evaluates insurance with narrow framing we show that due to aversion to risk on the net insurance payoff i e insurance indemnity minus insurance premium narrow framing reduces insurance demand this helps explaining the observed low insurance demand in many insurance markets we also show that the optimal insurance contract involves a deductible and the coinsurance of losses above the deductible when transaction costs depend on the actuarial value of the policy moreover when the policyholder is loss averse over the net insurance payoff a fixed indemnity equal to insurance premium should be paid for a range of intermediate losses

wealth inequality and asset pricing in an arrow debreu exchange economy with identical agents except for their initial endowment we examine how wealth inequality affects the equilibrium level of the equity premium and the risk free rate we first show that wealth inequality raises the equity premium if and only if the inverse of absolute risk aversion is concave in wealth we then show that the equilibrium risk free rate is reduced by wealth inequality if the inverse of the coefficient of absolute prudence is concave we also prove that the combination of a small uninsurable background risk with wealth inequality biases asset pricing towards a larger equity premium and a smaller risk free rate the model of the representative consumer a la lucas 1978 failed to explain observed security prices more specifically as first stated by mehra and prescott 1985 the model predicts an equity premium that is too low and a risk free rate that is too high given the observed low variability of consumption growth a recent strand of the literature with papers by constantinides and duffie 1996 heaton and lucas 1996 and krusell and smith 1997 for example explores whether incomplete asset markets and heterogeneity among consumers can explain these puzzles constantinides and duffie 1996 in particular conclude that it is at least in principle possible to generate larger equity premia when such ingredients are introduced the aim of this paper is not to provide another explanation of the puzzles but rather to better understand the relationship between asset prices the heterogeneity of consumers wealth and the market incompleteness when markets are complete heterogeneous consumers are able to equalize their marginal rates of substitution across states and across time as shown by constantinides 1982 this implies that the equilibrium of the heterogeneous consumer economy can be duplicated by the equilibrium in a lucas economy with a representative agent this means that taking account of the heterogeneity in the population alone cannot explain why the representative agent model is rejected hansen and singleton 1982 this does not mean however that the distribution of wealth in the population for example has no effect on asset prices in general in order to understand this consider the departure from an egalitarian distribution of wealth by introducing a mean preserving transfer of endowment under decreasing absolute risk aversion poorer agents will be more risk averse whereas wealthier people will be less risk averse there is no reason a priori for that the group s attitude towards risk be unaffected by this transfer we first show that if absolute risk tolerance i e the inverse of the arrow pratt coefficient of absolute risk aversion is concave then the risk aversion of the agent with the mean wealth will be smaller than the risk aversion of the representative agent thus if an outside observer overlooks wealth inequality he consequently underestimates the aversion to risk of society this leads to

moral hazard and background risk in competitive insurance markets we examine the effect of background risk on competitive insurance markets with moral hazard if policy holders have non negative prudence then background risk does not decrease effort and when effort increases expands the set of feasible policies however the effect of background risk on equilibrium is indeterminate we analyse the choice between stock and mutual insurance mutual insurance is equivalent to a fair policy plus background risk our results imply that competitive insurance markets with moral hazard should be dominated by stock insurers

how the demand for insurance became behavioral abstract recent developments in research on insurance reveal a shift towards behavioral insurance decisions remain rational but in a broader framework of reference that accounts for the role of loss aversion ambiguity framing reference points and emotions in people s decisions in this special issue many of those points are discussed in connection with the demand for insurance some of the major insurance puzzles such as insufficient demand for coverage the crowding out effect between insurance mechanisms and the opportunism in the insurance market that arises from asymmetric information are covered this paper introduces 24 texts on behavioral insurance

insurance cycles interest rates and the capacity constraint model insurance profits exhibit cyclical behavior that has been attributed to capital market constraints the authors show that changes in interest rates simultaneously affect the insurer s capital structure and the equilibrium underwriting profit depending upon asset and liability maturity structure capital market access and reinsurance availability insurers will be differently affected by changing interest rates the authors find that the average market response to changing interest rates roughly tracks market clearing prices these cyclical effects are enhanced for firms with mismatched assets and liabilities and more costly access to new capital and reinsurance this evidence supports the capacity constraint hypothesis copyright 1995 by university of chicago press

do you trust your insurer ambiguity about contract nonperformance and optimal insurance demand abstract we study optimal insurance demand for a risk and ambiguity averse consumer under ambiguity about contract nonperformance ambiguity aversion lowers optimal insurance demand and the consumer s degree of ambiguity aversion is negatively associated with the optimal level of coverage a more pessimistic belief and greater ambiguity may increase or decrease the optimal demand for insurance and we determine sufficient conditions for a negative effect we also discuss wealth effects and evaluate the robustness of our results by considering several alternative models of ambiguity aversion our findings show how ambiguity about contract nonperformance can undermine the functioning of insurance markets making it a concern for regulators caution is required though because demand reactions are only imperfectly informative about the welfare effects of ambiguity about contract nonperformance

increases in risk and deductible insurance abstract this paper examines how mean preserving transformations in the loss distribution affect the optimal level of deductibility in an insurance contract if marginal utility is convex increases in risk affecting losses only below the deductible are shown to lead to a reduction in coverage higher deductible which can be viewed as an increase in precautionary savings on the other hand a transformation that spreads losses more towards the tails of the distribution leads to an increase in coverage lower deductible whenever preferences exhibit nonincreasing absolute risk aversion

price regulation in property liability insurance a contingent claims approach a discrete time option pricing model is used to derive the fair rate of return for the property liability insurance firm the rationale for the use of this model is that the financial claims of shareholders policyholders and tax authorities can be modeled as european options written on the income generated by the insurer s asset portfolio this portfolio consists mostly of traded financial assets and is therefore relatively easy to value by setting the value of the shareholders option equal to the initial surplus an implicit solution for the fair insurance price may be derived unlike previous insurance regulatory models this approach addresses the ruin probability of the insurer as well as nonlinear tax effects

strategic risk taking when there is a public good to be provided privately abstract we describe a situation where a risk averse individual has a preference for risk taking in the literature we find this strategic risk behaviour in an altruistic framework where the individual actually benefits from his noninsurance only in the loss outcome in our model all agents are perfectly selfish when a public good is to be provided privately after the insurance decision the player facing greater uncertainty can expect an income transfer from the other individuals through the commitments to the public good this ex ante income transfer is not conditional on the loss

an analysis of the principal agent problem most analyses of the principal agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent s utility being at a stationary point an important paper of mirrlees has shown that this approach is generally invalid we present an alternative procedure if the agent s preferences over income lotteries are independent of action we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem we use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem

livestock disease indemnity design when moral hazard is followed by adverse selection averting or limiting the outbreak of infectious disease in domestic livestock herds is an economic and potential human health issue that involves the government and individual livestock producers producers have private information about preventive biosecurity measures they adopt on their farms prior to outbreak ex ante moral hazard and following outbreak they possess private information about whether or not their herd is infected ex post adverse selection we investigate how indemnity payments can be designed to provide incentives to producers to invest in biosecurity and report infection to the government in the presence of asymmetric information we compare the relative magnitude of the first and second best levels of biosecurity investment and indemnity payments to demonstrate the tradeoff between risk sharing and efficiency and we discuss the implications for status quo u s policy

a note on insurance coverage in incomplete markets in this paper full insurance coverage on average is defined as the coinsurance rate that eliminates all insurable risk when the uninsurable risk is evaluated at its mean the regressibility assumption is used to derive the conditions on the correlation between background and insurable risks and the actuarial unfairness of insurance under which full over or underinsurance on average is optimal these conditions are compared to those for the case of default risk together they explain intuitively the different results under the cases of background risk and default risk obtained in the literature

should central banks target cpi futures the author considers recent proposals that the government should attempt to stabilize the nominal value of a cpi futures contract under a variety of conditions arbitrageurs will break the peg and bankrupt the central bank the central bank ends up in a gaming problem with private traders or the regime collapses into discretion copyright 1997 by ohio state university press

optimal area yield crop insurance reconsidered the implementability of area yield insurance contracts in the presence of symmetric and asymmetric information about the farmer s beta linking his yield to the risk pool s yield is examined in the presence of fixed costs and symmetric information mahul s result that optimality requires setting the slope of the indemnity schedule equal to each farmer s beta is confirmed when there is asymmetric information between the insurer and the farmer however this full insurance contract is vulnerable to adverse selection and therefore may not be implementable for general cost structures the optimal area yield insurance contract under asymmetric information is characterized

high growth and low consumption in east asia how to improve welfare while avoiding financial failures this paper analyzes certain policies that are typical of a number of rapidly growing east asian countries in which a fixed exchange rate combined with a surplus labor market has made domestic assets relatively inexpensive generating high rates of fdi as well as domestic capital formation this investment hunger can lead to unanticipated declines in the returns to investment and resulting financial insolvencies private consumption remains low and there are concerns that high savings rates cannot be sustained we construct a dynamic general equilibrium model and apply it to a stylized asian economy loosely based upon china we calibrate a benchmark equilibrium and carry out various counterfactual simulations to analyze alternative policies in particular tax cuts and exchange rate revaluations as instruments in increasing private consumption while avoiding bank failures

the optimal deductible for an insurance policy when initial wealth is random individual wealth typically includes risky assets often some of these risks are insurable but other risks such as market valuation of stocks inflation and other general economic conditions are usually not insurable a series of recent papers by kihlstrom romer and williams 1981 ross 1981 nachman 1982 and pratt 1982 have shown that the introduction of background risk requires stronger definitions of risk aversion we will use some of these results to examine the choice of the optimal deductible in an insurance contract when initial wealth is random an examination of insurance purchases within a broader portfolio is considered by doherty 1981 and by mayers and smith 1983 these papers use a mean variance framework to examine the separability of the insurance decision in general portfolio relationships have nontrivial implications for insurance buying strategies in particular correlation between insurable and noninsurable risk may affect the optimal level of insurance coverage deductible insurance is considered mainly because of its widespread use by many insurers furthermore deductibles the literature concerning the choice of optimal deductibles for insurance policies assumes that wealth is nonstochastic except for the value being insured however a decision maker s asset portfolio might easily contain other sources of risk some of which might be uninsurable this paper examines the choice of a deductible insurance contract in the presence of uninsurable background risk existing theorems concerning the optimality of full coverage are shown to hold only under restricted conditions concerning the correlation of insurable risk with other risky assets more general propositions are established and the effects of risk aversion are considered

second best insurance contract design in an incomplete market the optimal form of insurance contracts for multiple risks is examined a well known result in the literature is that under fairly general conditions an insurance policy with a deductible for aggregate losses is optimal real world markets however are typically incomplete in that they require separate contracts for separate loss exposures for instance insurable damage to one s home is not generally allowed to affect the insurance indemnity for unrelated insurable damage to one s automobile we show that separate deductibles are second best optima in this setting we compare the indemnity provided in this second best setting with first best solutions the effect of second best contracts on the individual s total insurance demand is also examined

moral hazard and nonexclusive contracts we study equilibria for economies with hidden action in environments in which the agents contractual relationships with competing financial intermediaries cannot be monitored or are not contractible upon we fully characterize equilibrium allocations and contracts for such economies as well as discuss their welfare properties depending on the parameters of the economy either the optimal action choice is not sustained in equilibrium or if it is agents necessarily enter into multiple contractual relationships and intermediaries make positive profits even under free entry conditions the main features and implications of these environments are consistent with several stylized facts of markets for unsecured loans

the design of an optimal insurance policy almost every phase of economic behavior is affected by uncertainty the economic system has adapted to uncertainty by developing methods that facilitate the reallocation of risk among individuals and firms the most apparent and familiar form for shifting risks is the ordinary insurance policy previous insurance decision analyses can be divided into those in which the insurance policy was exogenously specified see john gould jan mossin and vernon smith and those in which it was not see karl borch 1960 and kenneth arrow 1971 1973 in this paper the pioneering work of borch and arrow the derivation of the optimal insurance contract form from the model is synthesized and extended

risk aversion and the propensities for self insurance and self protection for a risk averse individual the methods for reducing the expected financial impact of a loss include reducing the severity of any loss that occurs self insurance and reducing the probability of the occurrence of a loss self protection the literature on this topic has pointed to several anomalies whereby the use of self protection and self insurance yield quite unsimilar results for example ehrlich and becker 5 show that self insurance is always a substitute for market insurance an insurance company s indemnifying a loss whereas self protection and market insurance might be complements dionne and eeckhoudt 4 show that a more risk averse consumer would always invest more in self insurance activities but not necessarily more in self protection activities they argue 4 42 that this result is counterintuitive and provides an exception to the widely accepted result that increased risk aversion reduces risky activities ehrlich and becker 5 639 argue that the incentive to self protect is not so dependent on attitude towards risk both of the above papers seem to take for granted that self protection activities reduce the riskiness of the final wealth distribution however as we argue below this is not the case if riskiness is defined as in rothschild and stiglitz 14 even if we use the variance as our risk measure we do not always reduce risk via self protection dionne and eeckhoudt suggest that these results might not be robust enough to extend to models that incorporate random initial wealth risk and state dependent preferences we show that the model seems to be very robust we also explain why self protection is not at all an exception to the long standing result of arrow 1 whereby more risk averse individuals undertake a lower

optimal insurance against climatic experience an optimal insurance contract against a climatic risk is derived in the presence of an uninsurable and dependent aggregate production risk the optimaldesign depends on the stochastic dependency between both sources of uncertainty and on the producer s attitude towards risk especially on his prudent behavior rationalweather insurance purchasing decisions are al so derived the prudent producer responds to actuarially fair weather insurance by increasing his exposure towards risk the u s multiple peril crop insurance program in which indemnity payments are based on the producer s individualyiel ds has been disappointing in that premiums have not been sufficient to cover indemnity payments and administrative costs this failure has induced the u s government to promote alternative insurance policies since 1993 the risk management agency has offered areayield contracts under its group risk plan in selected counties skees black and barnett another alternative is to base the indemnity on a weather index such as rainfall or temperature this policy was proposed in the past by sanderson but has failed to gain acceptance among policy makers the difficulties of rainfall insurance were a subject of debate in australia e g bardsley abey and davenport quiggin 1986 patrick the recent development of weather based instruments on financialmarkets known as weather derivatives for which the payoff depends on the cause of risk rather than on its effect on yield provide new opportunities for covering exposure to unfavorable weather events the objective of this article is threefold first a stochastic production function affected by a climatic risk and by an aggregate production risk where both sources of risk are stochastically dependent is de

a utility and cpt based comparison of life insurance contracts with guarantees abstract some recent literature studies whether contracts including financial guarantees can be preferred by a utility maximizing investor the main result for contracts exposed solely to financial risk e g doskeland and nordahl 2008 dichtl and drobetz 2011 is that expected utility theory eut fails to interpret demand for guarantees while cumulative prospect theory cpt is able to support the demand while the development of the financial market has a significant impact on the portfolio choice some other non financial risk might play an important role too in the present paper we take life insurance products as an example where the long term nature of these contracts places a special emphasis on the uncertain lifetime of the investor we incorporate the mortality risk and investigate its effect on the attractiveness of contracts offering minimum interest rate guarantees to eut and cpt investors for this purpose we introduce two approaches for the consideration of multiple risk sources within cpt we illustrate the theoretical framework with numerous simulations and our numerical results show that a long term risk averse eut investor prefers products with guarantees

optimal random monetary policy with nominal rigidity abstract this paper studies a money in the utility function model with imperfect competition and one period ahead nominal price setting under standard assumptions on preferences friedman s rule setting the money growth rate equal to the household time discount factor generates an equilibrium that is optimal within the class of deterministic policies we then provide conditions under which a random monetary policy increases ex ante expected welfare relative to friedman s rule the result obtains because random policy can reduce the distortion associated with imperfect competition our result exhibits original features relative to existing cases of welfare improving random monetary policy such as polemarchakis and weiss j econom theory 15 1977 345

the design of an optimal insurance policy note in an article in this review arthur raviv 1979 examines pareto optimal insurance policies when an insurer incurs settlement costs c induced by indemnity i for loss x raviv s main result is that a necessary and sufficient condition for the pareto optimal deductible to equal zero is c i 0 this implies that deductible policies give the best tradeoff between risk sharing and economizing on costly claim settlements since in practice these costs are significant the theorem is of considerable importance among others this has been recognized by robert townsend 1979 michael brennan and ray solanki 1981 david mayers and clifford smith 1981 gur huberman mayers and smith 1983 harris schlesinger 1981 and stuart turnbull 1983 the theorem is correct but raviv s proof is not in this note a corrected proof for the theorem is given the corrected proof is important in itself because it allows for a generalization to a greater variety of transactions costs than has previously been considered see my 1984 paper for details section i develops the setting for the problem and the notation to be subsequently used raviv s error and the corrected proof are presented in section ii

natural catastrophe insurance when should the government intervene this paper develops a theoretical framework for analyzing the decision to provide or buy insurance against the risk of natural catastrophes in contrast to conventional models of insurance the insurer has a non zero probability of insolvency which depends on the distribution of the risks the premium rate and the amount of capital in the company when the insurer is insolvent each loss reduces the indemnity available to the victims thus generating negative pecuniary externalities our model shows that government provided insurance will be more attractive in terms of expected utility as it allows these negative pecuniary externalities to be spread equally among policyholders however when heterogeneous risks are introduced a government program may be less attractive in safer areas which could yield inefficiency if insurance ratings are not chosen appropriately

pricing in microinsurance markets summary microinsurance markets have exhibited strong growth rates in recent years great parts of the industry are however challenged by fundamental issues of providing insurance products one of the most significant of which is pricing risk in this paper we provide a nontechnical analysis of insurance pricing problems and a review of the set of opportunities that can address some of the specific pricing constraints in microinsurance markets a key contribution of this paper is the investigation of conventional techniques as potential solutions for improving the pricing of insurance risk in microinsurance markets

indirect hedging of exchange rate risk abstract the purpose of this study is to investigate the impact of exchange rate risk upon export production when the firm cannot engage in a direct forward hedge in the exchange rate however there exists a forward market for a domestic financial asset correlated with the exchange rate in question exporting firms using such an indirect hedging device to reduce foreign exchange risk do not necessarily increase their output when such unbiased hedging market becomes available this contrasts with the well known result in the case of direct hedging

income tax deductions for losses as insurance the federal income tax allows deductions for some categories of personal losses notably for casualty losses such as destruction of one s home or car and medical expenses above a threshold the latter even with lower marginal rates and further restrictions brought about by the 1986 tax reform involves more than a 3 billion annual revenue loss office of management and budget 1990 1 deductions like these act as partial insurance individuals receive a tax benefit equal to their marginal rate multiplied by the magnitude of their loss however this form of insurance is unnecessary when private insurance is available moreover as will be emphasized here these deductions have a perverse effect because they are allowed only for the uninsured portion of losses this induces individuals to be less protected against risk in the aggregate than if the implicit insurance provided by the tax system were unavailable if the tax rate is sufficiently high individuals would forgo insurance coverage altogether 2 it will be demonstrated that a tax system with no deductions for personal losses pareto dominates the current system these conclusions are demonstrated in section i using a simple model in which risk averse individuals may purchase actuarially fair insurance against loss and individual behavior does not affect the risk of loss no moral hazard section ii considers the applicability of the results when one allows for moral hazard administrative costs and other imperfections it also discusses the applicability of traditional notions of tax equity

the performance of alternative valuation models in the otc currency options market abstract we compare option valuation models based on regime switching garch and jump diffusion processes to a standard smile model in which black and scholes 1973 implied volatilities are allowed to vary across strike prices the regime switching garch and jump diffusion models provide significant improvement over a fixed smile model in fitting gbp and jpy option prices both in sample and out of sample the jump diffusion model achieves the tightest fit a time varying smile model however provides hedging performance that is comparable to the other models for the gbp options this result suggests that standard option valuation techniques may provide a reasonable basis for trading and hedging strategies

risk sharing in the adjustable rate loan market are existing contracts efficient abstract a previous paper arvan and brueckner 1986 showed that in an optimal loan contract interest rate risk should be shared between lender and borrower with the slope of the loan rate function which relates the loan interest rate to the lender s uncertain cost of funds lying between zero and one existing adjustable rate mortgage arm contracts violate this rule since they require complete risk absorption by the borrower when interest rate caps are not binding the present paper shows that when the earlier model is modified by adding a second type of borrower efficient loan contracts look more like existing arms

exclusive vs independent agents a separating equilibrium approach abstract we provide a separating equilibrium explanation for the existence of the independent insurance agent system despite the potentially higher costs of this system compared to those of the exclusive agents system or direct underwriting a model is developed assuming asymmetric information between insurers and insureds the former do not know the riskiness of the latter we also assume that the claims service provided by the independent agent system to its clients is superior to that offered by direct underwriting system that is insureds using the independent agent system are more likely to receive reimbursement of their claims competition compels the insurers to provide within their own system the best contract to the insured it is shown that in equilibrium the safer insureds choose direct underwriting whereas the riskier ones choose independent agents the predictions of the model agree with previous research demonstrating that the independent agent system is costlier than direct underwriting the present model suggests that this does not result from inefficiency but rather from self selection the empirical implication of this analysis is that ceteris paribus the incidence of claims made by clients of the independent agents system is higher than that of clients of direct underwriting implications for the coexistence of different distribution systems due to unbundling of services in other industries such as brokerage houses and the health care industry are discussed

rational insurance purchasing consideration of contract nonperformance much of the analysis of rational insurance purchasing and hedging strategies has been undertaken on the basis of the expected utility hypothesis this decision framework has been used to reformulate the bernoulli principle that a risk averter rationally would fully insure at a fair premium other applications include the analysis of insurance at unfair premiums mossin 1968 and smith 1968 the effects of state dependent utility on the rational insurance purchase cook and graham 1977 the effects of risky background wealth doherty and schlesinger 1983 and mayers and smith 1983 and the design of the optimal insurance policy raviv 1979 such analyses have been conducted on the assumption that insurance policies are free of insolvency default risk this assumption stands in sharp contrast to the actuarial literature in which the insolvency risk or probability of ruin is a central focus of attention

dynamic asset pricing with non redundant forwards abstract in an incomplete market in which non redundant forward contracts contribute to span the uncertainty some standard results of portfolio theory must be amended when the investment opportunity set is driven by k state variables a k 3 mutual fund separation theorem is obtained in lieu of merton s k 2 fund separation result the additional fund is a portfolio that hedges the interest rate risk brought about by the optimal portfolio strategy itself second the mean variance efficiency of the market portfolio of cash assets is neither a necessary nor a sufficient condition for the linear relationship between expected return and beta to hold third the pricing equation for a forward contract is shown to contain an extra term relative to that for a cash asset term we name strategy risk premium

a state contingent production approach to principal agent problems with an application to point source pollution control two basic representations of principal agent relationships the state space and parameterized distribution formulations have emerged although the state space formulation appears more natural analytical studies using this formulation have had limited success this paper develops a state space formulation of the moral hazard problem using a general representation of production under uncertainty a closed form solution for the agency cost problem is derived comparative static results are deduced next we solve the principal s problem of selecting the optimal output given the agency cost function the analysis is applied to the problem of point source pollution control c 1998 published by elsevier science s a all rights reserved

optimal hedging in a futures market with background noise and basis risk abstract this paper examines hedging behavior in an incomplete market in which there exists an unhedgeable and uninsurable independent background risk in the case of a basis risk that satisfies the regressibility property the background risk might be partly endogenous background risk generally has an ambiguous effect on the optimal hedge ratio however if preferences exhibit standard risk aversion and the background risk is fully exogenous the qualitative effect of the added background risk is determinate and depends on the direction of any bias in the futures market in all cases the speculative component of the hedge ratio is reduced in the presence of background risk when the background risk is a basis risk and futures prices exhibit normal backwardation this qualitative effect need not hold and it depends in part on the direction of regressability for spot and futures prices

further toward a theory of agricultural insurance the economic theory of contracts is applied to agricultural insurance to show that given full information pareto optimal insurance contracts are actuarially fair provide full coverage and differ for each individual the information problems of moral hazard and adverse selection prevent pareto optimality from being attained several second best solutions to these problems are applied to agricultural insurance it is shown that information collection and the application of contract design principles are second best solutions which may achieve the benefits of insurance at less cost than the current practice of public subsidies in theory agricultural insurance is an efficient risk sharing mechanism in practice however agricultural insurance has been a costly means of transferring risk from farmers to governments and or other insurers to induce farmers to participate in agricultural insurance governments have borne significant subsidy costs hazell pomareda and valdes p 295 in a recent study ahsan ali and kurian aak concluded that public subsidies are necessary to make agricultural insurance viable they also showed that insurance will increase output relative to a case with no insurance thus insurance is beneficial particularly in less developed countries where increasing food supplies is a policy goal for this reason they concluded that public subsidization of insurance also is desirable their conclusions are derived from a simplified model of production with one output and one input in this article we consider a more general production model with multiple inputs and outputs we show that aak s conclusion about the benefits of insurance may not hold depending on the nature of the inputs and outputs as defined by the production function carl h nelson is an assistant professor of agricultural economics

designing optimal crop revenue insurance when the indemnity schedule is contingent on the farmer s price and individual yield an optimal crop revenue insurance contract depends only on the farmer s gross revenue however this design is not efficient if as is the case with available contracts the coverage function is based on imperfect estimators of individual yield and or price the producer s degree of prudence and the extent of basis risks have important influences on the optimal indemnity schedule in this broader context optimal protection is not provided by available u s crop insurance contracts and may include combinations of revenue insurance yield insurance futures and options contracts

the demand for microinsurance a literature review summary microinsurance has recently received much attention as a promising tool to protect poor individuals from important shocks yet voluntary demand from people has been low shedding doubt on the viability of microinsurance as a useful risk management tool to better understand this puzzle this paper reviews both the theoretical and empirical literature on the demand for insurance while people s lack of understanding of insurance does seem to limit the demand for it several more fundamental factors such as price quality limited trust in the insurer and liquidity constraints also seem to have an important role in explaining the puzzle

imperfect hedging and export production firms engaged in international operations are highly interested in developing ways to protect themselves from exchange rate risk the incentive for risk management comes from the enormous volatility of the floating foreign exchange rates our study shows that an exporting firm can benefit from hedging exchange rate risks even when no perfect hedge is possible since in reality not every currency is traded in a futures market 7 chap 15 the exporting firm uses futures contracts with other underlying assets whose spot prices are highly correlated with the foreign exchange spot rate in the real world hedging must often be accomplished by using futures contracts on different deliverable instruments such hedging may result in imperfect hedging as shown by anderson and danthine 1 eaker and grant 11 dellas and zilberfarb 9 broll wahl and zilcha 6 it has been shown in recent publications 12 8 15 13 23 16 2 14 5 18 22 that an international firm facing exchange rate risk can eliminate this risk altogether if it can use a currency forward market another financial asset or a portfolio of assets which is perfectly correlated to the exchange rate in the absence of such markets the firm can reduce its income risk by engaging in a hedging activity of assets correlated to the foreign exchange recent studies of firm behavior under exchange rate uncertainty examine the influence of futures markets on the export and hedging decision these papers derive two major theorems one is the separation theorem which states that when futures markets exist the firm s export production decision is determined solely by technology and input output prices including the futures prices this result holds if the gain from the futures contract is perfectly correlated with export revenue the other theorem is the full hedging theorem which asserts that with unbiased futures markets the firm completely avoids exchange rate risk by entering into optimum futures contracts

choice under uncertainty problems solved and unsolved ffifteen years ago the theory of choice under uncertainty could be considered one of the success stories of economic analysis it rested on solid axiomatic foundations it had seen important breakthroughs in the analytics of risk risk aversion and their applications to economic issues and it stood ready to provide the theoretical underpinnings for the newly emerging information revolution in economics 1 today choice under uncertainty is a field in flux the standard theory is being challenged on several grounds from both within and outside economics the nature of these challenges and of our profession s responses to them is the topic of this paper

changes in background risk and risk taking behaviour economic decision making under uncertainty often takes place in the presence of multiple risks and in markets that are less than complete as a consequence choices about endogenous risks sometimes must be made while simultaneously facing one or more immutable exogenous background risks that are not under the control of the agent and that are independent of endogenous risks it is somehow natural to assume that an exogenous deterioration in background wealth will cause an individual to take more care elsewhere if we define a deterioration for example as making the individual poorer by removing a fixed amount of initial wealth we know from pratt 1964 that decreasing absolute risk aversion dara of an individual s von neumann morgenstern utility function yields this natural result if on the other hand background wealth becomes riskier due to the addition of a zero mean risk that is also statistically independent of all other risks behavior will be more risk averse if and only if preferences are risk vulnerable as defined by gollier and pratt 1996 risk vulnerability described below in section 4 is a stronger notion than dara and includes proper risk aversion pratt and zeckhauser 1987 and standard risk aversion eeckhoudt and kimball 1992 kimball 1993 as particular cases but a deterioration in background wealth may encompass more complicated distribution changes than the introduction of another statistically independent risk in this paper we examine background wealth deteriorations that take the form of both general firstand second degree stochastic dominance changes in risk fsd and ssd respectively in particular we determine conditions that are both necessary and sufficient for each of these two types of background risk changes to imply more risk averse behavior on the part of the individual for the case of fsd changes this condition turns out to be ross stronger characterization of decreasing absolute risk aversion in the case of general ssd changes in the distribution of background wealth the condition derived is a stronger version in ross sense of the conditions characterizing preferences that are locally risk vulnerable in the sense of gollier and pratt the necessary and sufficient conditions derived are fairly restrictive upon preferences however if we take as positive behavior that individuals act in a more risk averse manner whenever the distribution of background wealth deteriorates these conditions place canonical limits upon appropriate utility representations at the very least they

the pricing of options with default risk this paper considers the pricing of options with default risk the comparative statics of such options can differ from those of ordinary options and early exercise of such american call options can be optimal several examples of options with default risk are considered traditionally it has been assumed that options have no default risk such an assumption is reasonable when one studies options traded on an organized exchange in the u s default on such options would require as cox and rubinstein 5 put it a very sudden and strong movement in stock prices one considerably more extreme than any on record p 71 however many options and financial assets containing option like payoffs are sold by firms that have limited assets for such options default is often a possibility that must be taken seriously in this paper we study how options subject to default risk which we hereinafter call vulnerable options are priced it turns out that many of the well established results of the option pricing literature see e g smith 12 and references therein do not hold for vulnerable options in particular the value of a vulnerable european option can fall with time to maturity with the interest rate and with the variance of the underlying asset furthermore it may pay to exercise early a vulnerable american option on a non dividend paying asset

insurance as a giffen good abstract can insurance be a giffen good this can never happen if the coefficient of relative risk aversion is less than or equal to one if this coefficient is greater than one it is possible but not empirically plausible

the basis risk of catastrophic loss index securities abstract using a windstorm simulation model developed by applied insurance research we analyze the effectiveness of catastrophic loss index options in hedging hurricane losses for florida insurers the results suggest that insurers in the two largest size quartiles can hedge losses almost as effectively using contracts based on four intrastate indices as they can using contracts that settle on their own losses many insurers in the third largest size quartile also can hedge effectively using the intrastate indices but most insurers in the smallest quartile would encounter significant basis risk hedging using a statewide loss index is effective only for the largest insurers

implications of incomplete performance for optimal insurance we investigate the demand for insurance when contracts are subject with positive probability to two distinct types of incomplete performance when partial performance means payment of some fraction of the indemnity under full performance the latter exhibits a disappearing deductible when partial performance is due to insufficient financial capacity optimal insurance contracts for any given level of financial capacity offer full marginal coverage above a deductible for either type of non performance the optimal deductible under full performance is positive when insurance is offered at an actuarially fair price

risk based pricing and the enhancement of mortgage credit availability among underserved and higher credit risk populations this paper estimates an option based hazard model of the competing risks of fha mortgage termination results indicate that the elevated default risks of loans originated among lower credit quality and minority borrowers are more than offset by the damped prepayment speeds of those loans so as to result in markedly lower loan termination probabilities among underserved borrower groups those damped termination risks translate into sizable reductions in risk premia to investors in simulated lower creditquality mortgage pools empirical findings suggest that such pooling and risk based pricing of fha insured mortgages could serve to substantially reduce housing finance costs among underserved borrowers so as to advance both their homeownership opportunities and related federal housing policy objectives

some stronger measures of risk aversion in the small and the large with applications the arrow pratt measures of risk aversion for von neumann morgenstern utility functions have become workhorses for analyzing problems in the microeconomics of uncertainty they have been used to characterize the qualitative properties of demand in insurance and asset markets to examine the properties of risk taking in taxation models and to study the interaction between risk and life cycle savings problems to name just a few applications equally importantly they have generated the linear risk tolerance class of utility functions which has provided canonical examples in such diverse areas as portfolio theory and the theory of teams despite these successes there have been a number of areas for which the results have been weaker than hoped it is natural to use the risk aversion measures to compare the behavior of individuals in risky choice situations for example consider the individual portfolio choice problem in a two asset world with a riskless asset and a risky asset if individual a has a uniformly higher arrow pratt coefficient of risk aversion than individual b then b will always choose a portfolio combination with more wealth invested in the risky asset but suppose that both assets are risky now there is no obvious sense in which the more risk averse individual can be said to hold a less risky portfolio but it seems strange that such a simple alteration should destroy the analytics which support the basic intuition similarly consider the basic insurance problem if one individual a is more risk averse than another b in the arrow pratt sense it follows that a will pay a larger premium to insure against a random loss than will b typically though an individual evaluates partial rather than total insurance that is only some gambles can be insured against and others must be retained in this case even when the gambles which are retained are independent from those which are insured it is no longer true that the individual whose arrow pratt measure of risk aversion is higher will pay a larger insurance premium the situation is no better when we consider comparative statics exercises for a single individual decreasing absolute risk aversion in the sense of arrow and

exogenous shocks contagion and bank soundness a macroeconomic framework abstract in a model where all banks are initially solvent an exogenous shock affects confidence causing a flight from deposits into domestic and foreign currency real interest rates increase unexpectedly affecting firms and raising the share of the banks nonperforming assets this contagion causes a bank run simulations show that compensatory monetary policy mitigates the bank run but causes macroeconomic imbalances combining compensatory monetary policy with tight fiscal policies slows the bank run and mitigates insolvency a devaluation combined with compensatory monetary policy reduces insolvencies and increases the growth of real income but at the cost of increased inflation

a model for the determination of fair premiums on lease cancellation insurance policies lease cancellation insurance protects the lessor against early termination of a cancellable operating lease this paper presents a contingent claims model for determining the fair premium for this type of insurance policy comparative statics are considered and some numerical examples are presented to illustrate the model among other things the insurance premium is sensitive to the expected rate of economic depreciation of the leased asset and to the leased asset s systematic and nonsystematic risk

insurability and moral hazard in agricultural insurance markets pareto optimal and constrained pareto optimal all risk insurance contracts are studied conditions required for emergence of competitive insurance markets are isolated and discussed full insurance contracts are shown to be dominated by contracts involving coinsurance and deductibles if insurers are pseudo risk averse the effect of moral hazard on all risk agricultural insurance indemnity schedules is examined results for indemnity schedules under moral hazard and constant absolute risk aversion show that providing farmers with the incentives to take appropriate actions may imply lower deductibles in the presence of moral hazard than in the absence of moral hazard

how might climate change influence farmers demand for index based insurance the low observed uptake of non subsidised index based insurance policies in developing countries has been puzzling researchers for about a decade this paper analyses the role of drought frequency in farmers demand for index based insurance in developing countries while it is typically assumed that an increase in exposure to risk would result in higher demand for index insurance this paper finds the opposite an increase in drought frequency may result in lower demand for index insurance under fairly standard conditions in an expected utility model we show that the demand for insurance is an inverted u function of drought frequency we further show that downside basis risk decreases insurance demand under frequent drought conditions it implies that insurance against similar but more frequent events cannot meet large demand from farmers to check the empirical relevance of these effects we conduct an insurance field experiment in burkina faso with 205 farmers we analyse insurance demand for different drought frequencies different levels of basis risks and different loading factors through incentivised lottery choices this analysis confirms that for higher drought frequencies insurance demand is lower insurance demand also decreases with basis risk and the loading factor

bank failures and fiscal austerity policy prescriptions for a developing country abstract this work employs a dynamic general equilibrium model to evaluate the causes and implications of bank insolvencies we apply the model to stylized data from bangladesh a country whose banking system is currently suffering from large stocks of non performing assets the model is used to derive positive conclusions about alternative policy instruments designed to alleviate the impact of these insolvencies a benchmark case is simulated using historical exogenous parameters we then generate a bank failure by assuming that firms cannot service their debt if their interest obligations rise above their anticipated return on capital the public withdraws deposits from the banking system in reaction to worries about defaulting bank assets if banks optimize by restricting credit to risky borrowers these failures can be partially avoided such bank behavior is often prohibited in developing countries so we investigate an active monetary policy that compensates banks for withdrawn deposits the resulting outcome indicates that such a policy can slow the pace of bank failures although at the cost of certain macro imbalances our final simulation imposes a reduction in public spending in order to tighten fiscal policy and thereby reduce budgetary pressure the resulting decline in interest rates eliminates all investor defaults and bank failures we conclude that the combination of compensating monetary policy and restrictive fiscal policy may offer the best way of responding to a bank crisis

efficient contracts in credit markets subject to interest rate risk an application of raviv s insurance model interest rate risk borne by financial institutions has increased markedly as the credit markets have become more unstable in recent years the burden of this new instability has been especially severe for lending institutions whose balance sheets show the greatest mismatch between the maturities of assets and liabilities the savings and loan industry for example which borrows short and lends long suffered serious losses in recent years as income from its portfolio of old mortgages failed to keep pace with the escalating cost of short term funds the specter of such losses has led to the emergence of adjustable rate mortgages arms as well as other types of variable rate contracts these contracts often specify a complex functional relationship between the future loan interest rate and the lender s uncertain future cost of funds in view of the growing popularity of variable rate loans it is important to know what features an efficient contract of this type would possess to answer this question the present paper derives the form of the optimal variable rate contract focusing especially on the contractual relationship between the loan rate and the future cost of funds the framework used in the analysis is very similar to artur raviv s 1979 optimal insurance model section i derives the form of the optimal loan contract and evaluates the risk sharing efficiency of arms in light of the results subsequent sections discuss extensions of the model and offer conclusions 1 i analysis