Modem insurance economics has been deeply influenced by the recent developments in contract theory. Our understanding of such crucial aspects as the design of optimal insurance contracts, the form of competition in insurance markets, or the role of public regulation, just to name a few, systematically refers to the basic concepts of contract theory – moral hazard, adverse selection, commitment, renegotiation, and others.
Conversely, it is fair to say that insurance has been, and to a large extent still remains, one of the most important and promising fields of empirical application for contract theory.
By their very nature, insurance data provide nearly ideal material for testing the predictions of contract theory. As argued by Chipper (1994) and Chipper and Salami (1997), most predictions of contract theory are expressed in terms of a relationship between, on the one hand, some “performance” that characterizes the outcome of the relationship under consideration, and on the other hand, some transfers taking place between the parties.
Under moral hazard, for instance, the transfer will be positively correlated with the outcome, but in a smoothed way, in order to conjugate incentives and risk sharing; under adverse selection, the informed party will typically be asked to choose a particular relationship between transfer and performance within a menu, the latter being generally proposed by the other party.
Also, the exact translation of the notions of “performance” and “transfer” obviously varies with the particular field at stake. Depending on the particular context, the “performance” may be a production, a profit, the realization of a given task or the occurrence of an accident; whereas the transfer can take the form of a wage, a dividend, an insurance premium and others.
In all cases, empirical estimation of the underlying theoretical model would ideally require a precise recording of
- the contract,
- the information available to both parties,
- the performance, and
- the transfers. In addition, the contracts should be to a large extent standardized, and large samples should be considered, in order to apply the usual tools of econometric analysis. As it turns out, data of this kind are quite scarce. In some contexts, the contract is essentially implicit, and its true implications are uneasy to grasp.
More frequently, contracts do not present a standardized form because of the complexity of the information needed either to characterize the various (and possibly abundant) states of the world that should be considered or to precisely describe each party’s information.
In many cases, part of the information at the parties’ disposal is simply not observed by the econometrician, so it is de facto impossible to condition it as required by the theory. A typical example is repeated contracts, where the history of past relationships may provide
Crucial indications that in general are not (fully) available for the purpose of empirical observation. Last but not least, the “performance” is often not recorded, or even not precisely defined. In the case of labor contracts, for instance, the employee’s “performance” is often the product of a supervisor’s subjective estimation, and may not be recorded on the firm’s files.
In contrast, insurance contracts basically fulfill all of the previous requirements. Automobile insurance provides a typical example. Here, contracts are largely standardized. The insurer’s information is accessible, and can generally be summarized through a reasonable number of quantitative or qualitative indicators. The “performance” – whether it represents the occurrence of an accident, its cost, or both – is in general very precisely recorded in the firms’ files.