Posted: 14 Nov 2001
In standard models of contracts, efficient incentives require the promisor to pay damages for non-performance and the promisee to receive no damages. To give efficient incentives to both parties, we propose a novel contract requiring the promisor to pay damages for nonperformance to a third party, not to the promisee. In exchange for the right to damages, the third party pays the promisor and promisee in advance before performance or nonperformance occurs. We call this novel contract "anti-insurance" because it strengthens incentives by magnifying risk, whereas insurance erodes incentives by spreading risk. Anti-insurance is based on the general principle that when several parties jointly create risk, efficient incentives typically require each party to bear the full risk. Without a third party, the most that can be achieved is to divide the risk among the parties. By improving incentives, anti-insurance contracts can create value and benefit everyone as required for a voluntary exchange.
JEL Classification: A1, D0, D8, K0, K10, K12, K13, K42, L0
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