Moral Hazard, Basis Risk, and Gap Insurance

16 Pages Posted: 21 Jan 2003

See all articles by Neil A. Doherty

Neil A. Doherty

University of Pennsylvania - Insurance & Risk Management Department; University of Pennsylvania - Business & Public Policy Department

Andreas Richter

Ludwig Maximilian University of Munich - Faculty of Business Administration (Munich School of Management)

Abstract

This article addresses the trade-off between moral hazard and basis risk. A decision maker, e.g., a primary insurer, is considered who can purchase an index hedge and a (re)insurance contract that covers the gap between actual losses and the index-linked payout, or part of this gap. The results suggest that combining insurance with an index hedge may extend the possibility set and by that means lead to efficiency gains. Naturally, the results depend heavily on the transaction costs associated with both instruments. In particular, the authors show that if the index product is without transaction costs, at least some index-linked coverage is always purchased, so long as there is positive correlation between the index and the actual losses. So under these circumstances, there is in any case a benefit from the availability of index products. Furthermore, it is shown that the index hedge would always be supplemented by a positive amount of gap insurance.

Suggested Citation

Doherty, Neil A. and Richter, Andreas, Moral Hazard, Basis Risk, and Gap Insurance. Journal of Risk & Insurance, Vol. 69, pp. 9-24, 2002. Available at SSRN: https://ssrn.com/abstract=312745

Neil A. Doherty (Contact Author)

University of Pennsylvania - Insurance & Risk Management Department ( email )

Philadelphia, PA 19104-6365
United States
215-898-7652 (Phone)
215-898-0310 (Fax)

University of Pennsylvania - Business & Public Policy Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6372
United States

Andreas Richter

Ludwig Maximilian University of Munich - Faculty of Business Administration (Munich School of Management) ( email )

Schackstra├če 4
Munich, 80539
Germany

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