University of Augsburg Lilia Filipova

Monitoring and Privacy in Automobile Insurance Markets with Moral Hazard

ARIAAugust 6, 2007

Quebec City

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Automobile insurers record data about

distance traveled frequency of trips when (time of the day, rush hour) duration of trips, stopovers where (type of road, speed limits) speed accelerations and braking space measuring usage of seatbelts airbag-functioning collision data tire pressure

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Related literature

imperfect exogenous signals: Holmström (1979), Shavell (1979), Harris / Raviv

(1979)

endogenous monitoring: random sampling - Townsend (1979), Dye (1986),

Lambert (1985)

endogenous precision of the signal - Singh (1985), Meth (1996), Kim / Suh (1992)

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Contract schemes (1)

conditional monitoring only the indemnities (I) depend on the monitoring

signal

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Contract schemes (2)

no restrictions on monitoring both (B) the premiums and indemnities depend on the

monitoring signal

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General setting of the model

perfectly competitive market with risk-neutral insurers

risk-averse individuals two possible outcomes: Loss (W-L) and No Loss (W) two effort levels, with probabilities of

NO Loss insurance contracts monitoring with comprehensiveness of data individuals’ utility

with and

),( dr

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General setting of the model

monitoring technology generates a binary signal

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Conditional monitoring – endogenous precision (1)

maximization problem

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without privacy costs with privacy costs IC:

zero-profit constraint:

expected contractual utility

Conditional monitoring – endogenous precision (3) with

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without privacy costs with privacy costs marginal effect of precision

Conditional monitoring – endogenous precision (4)

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generally, when i increases: the signal becomes more informative of effort incentives on effort improve risk-sharing improves expected contractual utility increases

privacy costs: lead to an interior solution for i unless privacy costs

increase too fast reinforce the incentives on effort improve the allocation of risk increase the expected contractual utility decrease the total expected utility

Conditional monitoring – endogenous precision (6)

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Conditional monitoring – endogenous precision ex post

precision ex post effect is as if the level of precision was not observable additional incentive constraint: with respect to

precision risk sharing is worse

ex post flexibility of monitoring decreases the efficiency of the contract

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Comparison of the contract schemes

without privacy costs: Unrestricted monitoring (B) is more efficient than

conditional monitoring (I) for any level of precision i.

with privacy costs: B lacks the positive incentive and risk sharing effects

of privacy costs (indirect effects) with B the expected privacy costs are larger than

with I (direct effect)

I is better than B, if - the efficiency of effort is high, - the efficiency of the monitoring technology is low, - the probability of loss is small - the privacy costs with B are large

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Summary

without privacy costs: B with maximum amount of data is optimal

with privacy costs: unless privacy costs increase too fast, insureds will

choose some monitoring with any contract scheme with conditional monitoring (I)

- privacy costs have an incentive and a risk sharing effect,- the expected utility of net wealth increases,- however total expected utility decreases,

I gains advantages due to direct and indirect positive effects of privacy costs.

I can be more efficient than B

ex post precision is inefficient

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Thank you!