Optimal Casualty Insurance and Repair in the Presence of a Securities Market

Abstract

We build a simple economic model of optimal casualty insurance based on a story about insuring a house. With endogenous repair and a securities market that is complete over states distinguished by security payoffs, we have three main findings in our base model with additively separable preferences. First, optimal repair depends on security market conditions, with full repair in inexpensive states and little or no repair in expensive states. Second, the optimal insurance payment equals the cost of optimal repair. Third, the agent is not made whole, since the loss is fully compensated only when damage is fully repaired. Weaker versions of the results hold when preferences are not additively-separable. Quite generally, when full repair is optimal it is fully insured.

Keywords: optimal casualty insurance, optimal regulation

JEL Classification: G11, G22