Date Added: Jun 2009
Insurance regulation is often based on keeping probabilities of failure small and not on any explicit analysis of economic trade-offs. The authors build a simple economic model of optimal casualty insurance based on a story about insuring a house. This is done in the presence of a securities market that is complete over states distinguished by security payoffs. They show that partial insurance might be desirable, i.e. the optimal insurance policy fully insures the casualty loss in less expensive states and does not pay off anything in more expensive states. They also analyze a stylized model of insurance regulation imposing a maximum default probability.