Optimal Long-term Contracts with Disability Insurance under Limited Commitment

We study an optimal long-term labor contract that provides disability insurance benefits under two frictions: the agent cannot commit to a long-term contract and the disability shock is private information. We predict that a job with a high risk of disability should provide a higher level of salary but with a lower growth rate over time. We find that the optimal contract can be implemented under a three-account trading system in which mandatory savings can be imposed to discourage a worker from falsely claiming disability. We also investigate how the nature of disability shock has an impact on the optimal contract: a larger borrowing limit should be given to a worker with a high severity of the disability shock or a low arrival intensity. Finally, our quantitative analysis shows that the cost caused by current long-term disability insurance practice can be substantial.

Keywords: Disability Insurance, Limited Commitment, Truth-telling, Dynamic Contracting, Incentives

JEL Classification: C61, D47, D82, D86, E21, I13

Suggested Citation: Suggested Citation

Choi, Kyoung Jin and Jeon, Junkee and Lee, Ho-Seok and Lin, Hsuan-Chih, Optimal Long-term Contracts with Disability Insurance under Limited Commitment (Feburary 23, 2022). Insurance: Mathematics and Economics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3421296 or http://dx.doi.org/10.2139/ssrn.3421296