Optimal Insurance Policy Indemnity Schedules With Policyholders' Limited Liability and Background Risk

This article makes two contributions to the insurance literature by studying optimal insurance policy indemnity schedules with policyholders' limited liability and background risk. First, generalizing a prominent approach by Huberman, Mayers, and Smith (1983), it is shown that a welfare subsidy in the case of a ruinous loss may make the insurance premium 'overly fair' for non-bankrupting losses and full insurance for this event becomes optimal. Second, introducing correlated background risk into this limited liability framework relativizes or even turns results by Doherty and Schlesinger (1983) as to the impact of background risk on optimal coverage into its opposite.
Introduction Individuals often face multiple risks that can adversely affect their wealth and well-being. Illness, unemployment, death of a loved one, motor vehicle accidents, and natural catastrophes like floods or [...]