Optimal Long-term Contracts with Limited Commitment and Unobservable Disability
57 Pages Posted: 18 Jul 2019 Last revised: 29 Jan 2021
Date Written: January 28, 2021
We study a continuous-time model of an optimal long-term labor contract that has disability benefits under two frictions: the agent cannot commit to a long-term contract and the disability shock is private information. We provide a novel solution method and investigate how the two frictions affect the optimal contract. We find that the optimal contract can be implemented under a three-account trading system in which mandatory savings should often be imposed to discourage the agent from falsely claiming disability. Finally, our quantitative analysis shows that the cost caused by current long-term disability insurance practice can be substantial.
Keywords: Dynamic Contracting, Disability Insurance, Limited Commitment, Truth-Telling
JEL Classification: C61, D47, D82, D86, E21, I13
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