Dynamic Prevention in Short-Term Insurance Contracts

Article excerpt

ABSTRACT

This article looks at the dynamic properties of insurance contracts when insurers have a better technology at preventing catastrophic losses than the insured. When the prevention technology is irreversible and its benefits last for all future periods although its cost is borne in the period in which it is made, a hold-up problem occurs because the insured can change insurer after his initial insurer has invested in prevention. Investment in prevention is then delayed compared to the first best outcome. When the audit cost must be incurred by the insured when he wants to change insurer, the incumbent insurer has an informational advantage so that he can keep his client over the entire investment horizon, even though long-term contracts are not possible. This does not avoid the delay in investment, however.

INTRODUCTION

Typical articles on moral hazard and prevention assume implicitly if not explicitly that agents for whom prevention is valuable are aware of the best available practices. This is not necessarily the case, however. For example, a firm may not have the knowledge of the best available practices to reduce pollution (the firm produces golf carts and emits a toxic mercury by-product) or to manage computer hacker risk (the firm sells furniture and has all inventory and merchandise movement computerized). A firm's core competence may be so different from the competence needed to reduce risk that it needs outside help. Gains from trade then exist if prevention technology specialists sell their expertise to firms that need it. In some instances, the insurance industry is the best provider of prevention technology, especially in the case where the insurer is the underwriter.

Being faced with many risks of the same type in the same industry, insurers learn a great deal more than firms about the most efficient way to reduce risk (see Mayers and Smith, 1982; Doherty, 1997, for similar arguments). This is especially true for risks that are very rare so that only entities that deal with many possible exposures can correctly assess the quality of the prevention technology. Put another way, insurers have a comparative advantage in preventing catastrophes. Information technology management provides a good example. Firms generally have no special knowledge of their exposure to computer network and client database risk. Insurers, on the other hand, given their enduring financial and operational exposure to such risks, have acquired more efficient technological knowledge to prevent catastrophes. An insurer's claim specialist department (1) often provides risk assessments and offers consulting services and solutions for their clients. Insurers can also implement and service the prevention technology for their corporate clients (see van Santen, 1997; De Marcellis, 2000).

A second important aspect to consider regarding investments in prevention is that firms could be unable to finance the purchase of the prevention technology. For instance, information asymmetries and imperfect commitment could restrict access to credit and prevent firms from raising outside capital. This is especially true for small businesses that rely on bank debt rather than external equity as their principal financing source because they lack enough collateral to break the financing constraint they face (see Bester, 1987; Binks and Ennew, 1996). Even though bank finance helps reduce capital constraints, smaller firms with more risky returns are nevertheless more subject to capital constraints than larger firms (see Evans and Jovanovic, 1989; Holtz-Eakin, Joulfaian, and Rosen, 1994a,b).

A 1994 report by the U.S. Small Business Administration (SBA) stresses that many small businesses do not have banking relationships or enough collateral to secure the necessary funding for future development. In particular, the reports states that

   Banks recent measures to minimize their environmental risk have had
   a heavy impact on small businesses that handle dangerous chemicals
   or produce contaminated waste. …