Real-Time Monitoring and Relational Contracts in Usage-Based Insurance

Abstract

The rise of the Internet of Things (IoT) and big data technologies enables insurance companies to monitor policyholders’ behavior in real time, leading to innovative usage-based insurance (UBI). This paper studies the optimal UBI contract that employs both a traditional objective signal (e.g., official accident report) and a novel subjective signal (e.g., driver safety score) about the insured’s behavior in the presence of moral hazard. We show that under limited liability, the subjective signal may not be used even when enforceable if it is relatively imprecise. Moreover, the objective and subjective signals can serve as either complements or substitutes, depending on their precisions. While a more precise subjective signal always enhances insurance market efficiency, the welfare implication of the objective signal can be non-monotonic. In particular, when a more precise objective signal leads to a highly efficient traditional insurance contract, it may reduce the efficiency of the UBI contract or even make the subjective signal infeasible to use. Our paper thus explains the conditions under which UBI programs can emerge and highlights key factors for the success of UBI programs. In addition, we show that UBI market regulation can mitigate distortions in UBI contract design and investment in monitoring technologies.

Keywords: Usage-based Insurance, Relational Contract, Monitoring Technology

JEL Classification: D82, L52