2003 - Pareto Efficient Insurance Contracts - Carlier and Dana

Pareto Efficient Insurance Contracts When the Insurer's Cost Function Is Discontinuous
Author(s): Guillaume Carlier and Rose-Anne Dana

Source: Economic Theory, Vol. 21, No. 4 (Jun., 2003), pp. 871-893
Published by: Springer
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Economie Theory 21, 871-893 (2003) ?-;
Economic
Theory
? Springer-Verlag 2003
Pareto efficient insurance contracts

when the insurer's cost function is discontinuous*
Guillaume Carlier1 and Rose-Anne Dana2
1 GRAPE, Universit? Bordeaux 4 Montesquieu, Avenue L?on Duguit, 33608 Pessac, FRANCE
(e-mail: carlier@montesquieu.u-bordeaux.fr),
2 CEREMADE, Universit? Paris 9 Dauphine, Place de Lattre de Tassigny,
75775 Paris Cedex 16, FRANCE (e-mail: dana@ceremade.dauphine.fr)
Received: November 8, 2000; revised version: March 12, 2002
Summary. We consider the problem of efficient insurance contracts when the cost
structure includes a fixed cost per claim. We prove existence of efficient insurance
contracts and that the indemnity function in such contracts is non-decreasing in
the damage. We further show that either there is no insurance, or the indemnity
is positive for all losses, or efficient insurance contracts have a unique jump. We
study variants of the model and provide a generalization to the case of non expected
utilities. Our results are then applied to Townsend's model of deterministic auditing.
Keywords and Phrases: Efficient insurance contracts, Discontinuous cost func

tion, Auditing.
JEL Classification Numbers: C61, G22.
1 Introduction
Since Borch [4] and Arrow's early work [1,2] the design of efficient insurance
contracts has received a lot of attention. Arrow's original result that full coverage
of the loss above a deductible is optimal when the insured is risk averse and the
insurer risk neutral with linear cost has been generalized to many settings: risk
averse insurer, convex costs, non expected utility maximizers, etc...
Two lines of research are of particular interest in this paper. The first deals with
asymmetric information and exchange of risk. Townsend [20] elaborates on Rad
ner's [17] idea that imperfect and costly information should be taken into account
* We are grateful to F. Salani? for pointing out an error in the previous version of the paper and for
suggesting Proposition 6 to us.
Correspondence to: R.-A. Dana
872 G. Carlier and R.-A. Dana
when agents exchange risk. He develops a model, which is open to various interpre
tations (corporate finance, insurance), in which agents are asymmetrically informed
on the actual state of nature and in which the information can be transmitted only
at some cost. More precisely, in the case of insurance, only the insured knows the
state of the world unless the insurer bears an audit cost. In his setting, a contract is
a pre-state agreement as to when there is verification and the amount to be received
by the insured. A contract is incentive compatible if the insured does not falsify his
claim. Townsend shows that there exists a set of realizations over which there is no
verification and no claims are filed. He also shows that a verification set is a set of
high realizations of the loss.
The second line of research deals with non-convex costs. Huberman et al. [14]
first study the case of scale economies in administrative expenses. Later, when
considering the problem of "nuisance claims" (in other words claims for which the
reimbursement cost is small relative to the administrative expenses), Gollier [12]
introduces a framework where the cost structure includes a fixed cost per claim.
Existing models of deterministic auditing have built on Townsend and Gollier's
ideas. Indeed, Picard [15], [16] and Bond and Crocker [3] have developed models
of deterministic auditing under costly state verification. They consider different
auditor's information structures about the loss. This leads them to take into account
different incentive compatibility concepts.
In our paper, we take Gollier's model as a benchmark and apply our results to
models of deterministic auditing. The main contribution of the paper is to provide
methods to prove existence of efficient contracts and to study their qualitative
properties when one of the agents' criterion is not concave. Our results rely on
second order stochastic dominance and Hardy-Littlewood's inequality and not on
first-order conditions which may not apply in this setting. The non-convexity of
the cost being a source of difficulty in establishing existence of efficient contracts,
our first contribution is to prove existence of efficient contracts, without assuming
a priori any property of indemnity schedules. Our proof which is constructive is
based on an approximation method and on second order stochastic dominance
arguments. We then show that any efficient contract is non-decreasing with respect
to the loss. Hence we derive this property endogenously while in most of the papers
cited above, it is assumed. Moreover, we show that, either there is no insurance or
any loss is compensated by a positive indemnity or there is no insurance below a
threshold and a positive indemnity after the threshold.
We then show that our results may be applied to deterministic auditing in insur
ance fraud. We first prove existence of efficient incentive compatible contracts. We
then generalize Townsend's and Picard's results and show that if costs are convex, a
verification set necessarily is a set of high realizations of the loss. We further show
that only three cases exist:
- there is no verification and no indemnity,

- there is partial verification and the indemnity is discontinuous: it is zero on the
non-verification set and greater than a positive amount on the verification set,
- there is full verification and the indemnity is positive.
Pareto efficient insurance contracts when the insurer's cost function is discontinuous 873
The paper is organized as follows. In Section 2, we recall Gollier's model.

Section 3 is divided into two parts. In the first, we prove existence of efficient
contracts. In the second, we prove monotonicity properties of efficient contracts
and characterize them. In Section 4, we study variants of the model which are
relevant for insurance fraud. In Section 5, we show that all our results hold for a
class of non-expected utilities. Lastly, in Section 6, we apply our results to insurance
fraud.
2 The model
Insurance buyers face a loss X where X is a random variable with support [0, x]
and probability law p. It is assumed that p is absolutely continuous with respect to
Lebesgue's measure and has a positive density.
The insurance market provides insurance contracts for this loss. A contract is
characterized by a premium P and an indemnity schedule t : [0, x] ?> R which
satisfies 0 < t(X) < X a.e. on [0,x].
When the insured buys the contract, he is endowed with the random wealth
W(X) :=w0-P-X + t(X) (1)

where wo is the insured's initial wealth. For the sake of simplicity, from now on we
normalize wo = 0.
The insured is assumed to have von Neumann-Morgenstern preferences over
random wealth:
L
X
U(W(x))dp(x)
where U : R -? R is strictly concave, strictly increasing and C1. His indirect utility
over contracts is: _
v(t,P):= Jo
f U(W(x))dp(x)
By selling the contract the insurer gets P and promises to pay t(x) if loss x
occurs. His profit n(t, P) is assumed here to be of the following form
n(t, P):=P- /Joc(t(x))dp(x)

where the cost function c : R+ -> R satisfies : c(0) = 0 < c(0+) and c is convex,
increasing and C1 on (0, +oo). The jump c(0+) > 0 is interpreted as a fixed cost.
An important example is the case of an audit cost. Under our assumptions, the cost
function is only lower semi-continuous and is not convex on R+.
Our aim is to study Pareto efficient contracts. For the sake of completeness, we
recall some definitions.
Definition 1 1) A contract (t, P) is Pareto efficient iff there exists no contract

(f, Pf) such that v(t', P') > v(t, P), ir(t', P') > n(t, P) with at least one strict
equality.
2) Two contracts (t, P) and (tf, Pr) are utility equivalent iffv(t', P') =v(t,P)
and'K(t,,P') =ir(t,P).
As usual, we may parametrize Pareto efficient contracts by the profit level A of

the insurer. A contract (t, P) is Pareto efficient iff there exists ? G R such that it is
a solution of
sup v(t,P)
s.t.
7r(t,P) = X
Using this parametrization, Pareto efficient contracts that yield a level of profit
? to the insurer are then the solutions to the following problem:
sup J(t)
V{\) { s.t.
0 < t(x) < x a.e. in [0, x]
where
pX rX
J(t)
Jo :=
Jo/ U(-x A-
Contrary to the standard continuo
concave and may have no solution or
section the existence of solutions to
3 Pareto efficient contracts
3.1 Existence of Pareto-efficient con
From now on, we shall associate to t

a.e., the premium P given by:
P = A + /Jo
c(t(x))dp(x).
Lemma 1 If a contract t0 is such that J(t0) > J(t) for every continuous contract
t, then to is Pareto-efficient.
We next study a discretization of V(X), corresponding to the case where there

is a finite number of losses occurring with the same probability.
Let 0 < x\ < ... < xn < x. Consider the problem:
{suP(?!,...,tn) Jn(ti,...,tn)
S.t.
0 < U < Xi for all ? = 1,..., n
with
.. n t n
Jn(*l,...,*n) := - Y] U(-Xi + U - X-Y]c(tj))

i=l j=l
We then have:
Lemma 2 Vn has a sol

1) For all (i, j) G {1,..
(x? - Xj)(ti -
2) For all (i,j) G {1, .
\Xi XjJyXi Zi
3) With the conventi
{i:ti=0} = {0
Note that the previous c
Tn(.): [0,af] ?> [0,x]
Tn is positive and 1-Lip
Using the previous lem

tracts with almost stan
Theorem 1 For every

properties:
l)t* is non-decreasing,
2) there exists s* G [0,x] such that {?* = 0} = [0,5*] and t* is 1-Lipschitz in
(8*,x).
The proof which is constructive but rather long is given in the Appendix; it
consists of 3 steps:
In step 1, we study a sequence of discretizations of the problem and, using
Lemma 2, we find a subsequence of their solutions which converges to a contract
t* satisfying the statements of the Theorem.
In step 2, we discretize any continuous contract t in such a way that the sequence
of discretized costs converges to the cost of t.
In step 3, passing to the limit, we show that t* constructed in step 1 dominates
t and, using Lemma 1, we deduce that t* is efficient.
3.2 Characterization of efficient contracts
Up to now, we have proven the existence of an efficient contract such that, there
is no insurance below a threshold and a positive indemnity after the threshold. We
shall now prove that, any efficient contract fulfills these properties.
We first prove that efficient contracts have classical monotonicity properties on
the set of damages with positive indemnity.
Lemma 3 Ift is a solution ofV(X), then:

1) t is non-decreasing on the set {t > 0},
2) x *-> x - t(x) is non-decreasing on the set {t > 0},
3) t is 1-Lipschitz on the set {t > 0}.
To prove that efficient contracts are non-decreasing it remains to be shown

that the unknown set {t = 0} where no indemnity is paid necessarily is a set of
low realizations of the loss. To prove this result, we shall use some rearrangement
inequalities. Let us first specify our notations and recall some definitions.
Given t : [0,x] ?? [0,x], a /?-measurable function, there exists a unique non
decreasing function t such that
p({t< a}) = p({t < a}), for all a G [0,x\. (2)

Recall that (2) is equivalent to the equi-measurability of t and t which is defined
by:
PX~ pX~
/Jo
f(t(x))dp(x)Jo
= / f(t(x))dp(x) for every measurable function /. (3)
The function t is called the non-decreasin

Let A be a measurable subset of [0,x
measurable function A ?> [0,x], there ex
A, tA, suchthat
p({tA < o?} H A) = p({t <a}n

Note that (4) is equivalent to the equi-m
[ Ja
f(t(x))dp(x)
Ja = / f(t(x))dp(x) (5)
for every measurable /. The funct
of t with respect to A.
Let us state a useful inequality (
be a function of class C1 from [0
for all te
at \0,x], x i-> ? (x
We then have the following rearrangement inequalities which are an importan

tool for proving our main characterization Theorem.
Lemma 4 1) Let t: [0,x] -> [0,x] be a p-measurable function and let t be t

non-decreasing rearrangement oft. Then the following inequality holds:
px rX
I L(x,t(x))dp(x
Jo Jo
Moreover, there is equality in (7) if an
2) Let Abe a borelian subset of [0, x] with p(A) > 0, let the a p-measurable
function A ? [0,x] and let tA be the non-decreasing rearrangement oft with
respect to A. Then the following inequality holds:
/ Ja
L(x,tA(x))dp(x)
Ja > / L(x,t(x))dp(x). (8)
Moreover, there is equality in (8
Since U is of class C1, L(t, x

Using Lemma 3 and Lemma 4, w
Proposition 1 If t is a solution
{t ? 0} is an interval of the form
Finally we prove that the discont

have a jump (necessarily unique
Proposition 2 Ift is a solution
0 < 5* := inf{x G [0,x

then t is discontinuous at s*.
It follows from the previous pr

the properties stated in Theorem
then, either t = 0 (no insurance
loss) or it has one and only one
Theorem 2 For every profit le

properties:
l)t* is non-decreasing,
2) there exists s* G [0, x] such
(s*,x\.
Moreover, either t* = 0 or ifs* := inf{x G [0,x) : t*(x) > 0} G (0,x), then
t* is discontinuous at s*. In particular t* has at most one jump.
3) If the cost is affine on (0, +oo), then t*(x) = (x ? d)+l{x>iy for some pair
(d, I) satisfying x > I > d > 0.
4 Variants of the model
As we shall see in Section 6, in applications, insurance contracts are restricted to

certain classes because of incentive problems. The first class that we consider is
the class of contracts that are non-decreasing in the damage. Let us first introduce
a definition.
Definition 2 A pair (t, P) with t non-decreasing is X-Pareto efficient iff there does
not exist any pair (tf, P) with t' non-decreasing such that v(t', Pf) > v(t, P),
7r(tf ,Pf) > 7r(t,P) with at least one strict inequality.
Let us now prove that one may, without loss of generality, assume that a contract
is non-decreasing.
Theorem 3 A contract is Pareto efficient if and only if it is X-Pareto efficient.
Proof. Assume that t is Pareto-efficient. From Theorem 2, t is non-decreasing,

hence it is J-Pareto efficient. Conversely, let t* be J-Pareto efficient. Assume that
t* is dominated by a contract t that is not non-decreasing. From Theorem 2, t is
strictly dominated by a non-decreasing contract, contradicting the assumption that
t* is J-Pareto efficient. D
Remark. It can be seen that the existence and characterization of J-Pareto efficient
contracts may be obtained much more easily than the existence and characterization
of Pareto efficient contracts. Since J-Pareto efficient contracts are the solutions of
the optimization program obtained when adding the constraint "t non-decreasing"
to V(X), and using Helly's Theorem, from any maximizing sequence (tn), one
may extract, a sequence converging pointwise to a limit t*. Since J is upper semi
continuous, t* is J-Pareto efficient. In other words, the additional monotonicity
constraint makes the problem much easier precisely because, in this case, there is
no need to use fine rearrangement inequalities.
In the remainder of the paper, the identity map on [0, x] will be denoted Id,
Id(x) = x for all x G [0, x].
We now consider:
S = {t : [0, x] -> R such that t and Id ? t are non-decreasing}
A contract in S is called an S contract. S is the class of contracts for which the

insured has no incentive to inflate the level of the damage deliberately. Indeed, if
the wealth wo ? P ? X A- t(X) was not non-decreasing with X, then policy-holders
could deliberately increase the damage. Hence the additional constraint that Id ? t
is non-decreasing is often referred to as the no sabotage condition.
Definition 3 AS contract (t, P) is S-Pareto efficient iff there exists no S contract

(tf, Pf) such that v(t', P!) > v(t, P), 7r(t', Pf) > ir(t, P) with at least one strict
inequality.
Theorem 4 1) There exist S-Pareto efficient contracts.

2) Any S-Pareto efficient contract t such that {t > 0} ^ ?and{t > 0} ^ (0,x]
is strictly dominated by a Pareto efficient contract.
3) If the cost is affine on (0, +oo), then t* (x) = (x ? d)+for some d G [0, x].
Proof. Let us first remark that if t and Id?t are non-decreasing, then t is 1 -Lipschitz.
Let K := {t : [0,x] -> R such that t and Id - t are non-decreasing and 0 <
t(x) < x, V x e [0, x]}. It follows from Ascoli's Theorem that K is compact with
respect to the uniform topology on C?([0, x], R). As J is upper semi-continuous
on K, it follows from Weierstrass Theorem, that there exists an 5-Pareto efficient
contract at profit level A which proves assertion 1. It follows from Lemma 2 that
any continuous contract t such that {t > 0} ^ {0, (0,x]} is strictly dominated
by some Pareto efficient contract, hence assertion 2. Lastly assume that the cost is
affine on (0, +cxd) and that t* is 5-Pareto efficient. Let
d := ini{x G [0,x] such that t*(x) > 0}.

It follows from standard stochastic dominance arguments that t* (x) ?xis constant
in [d, x], hence t*(x) = (x - d)+ for all x G [0, x}. D
Remark. Clearly 5-Pareto efficient contracts do not coincide with X-Pareto efficient
ones since they are continuous.
5 More general utility functions
In Section 3, we have made extensive use of stochastic dominance arguments. Let

us now prove that our main results are robust to generalizations to the non expected
utility case.
When the cost function is continuous, it is well-known that, when the insured
has a behavior that does not conform to expected utility, efficient contracts may
have properties similar to those of the expected utility case (see Chew and Zilcha
[8], Gollier and Schlesinger [13], and Dana and Shahidi [10] for an overview of
available results). In this section, we show that the results obtained in Section 3
indeed extend to the non expected utility case.
In this section, Lp denotes Lp(dp, R), for all p G [1, +oo].
Let us recall that X^2Y (respectively X y2 Y) if E[U(X)} > E[U(Y)} for
every concave increasing function U : R ?> R (respectively the inequality is strict
for at least one concave increasing function).
Let V : L?? ? R be a utility function. We assume the following on V :
(Ul) V is "strictly weakly monotone" that is for all a > 0 and all X G L??,
V(X + a)> V(X).
(U2) V is continuous with respect to the L1 norm topology on every bounded
subset of L??.
(U3) X y2 Y implies V(X) > V(Y), \f(X, Y) e (L??)2 .
Examples and characterizations of strongly risk averse utilities may be found
in Chateauneuf et al. [6] and in Chew et al. [9].
Remark. Strong risk aversion does not imply concavity or quasi-concavity of V.

Consequently, in the following results, V is not assumed to be quasi-concave.
In this setting, a contract t is a Pareto-efficient contract if and only there exists
A G R such that t is a solution of Vy(X):
{sup Jv(t) := V(-x + t(x) - X - ?n c(t(s))dp(s))

s.t.
0 < t < Id /x-a.e.
Remark. If X and Y are bounded random variables such that E[U(X)] > E[U(Y)\
for every utility function U : R -> R which is strictly concave increasing of class
C1 and the inequality is strict for at least one such U then, using a standard density
argument, it can be easily checked that X y2 Y, hence V(X) > V(Y).
Theorem 5 Assume that V satisfies (Ul), (U2) and (U3), then :

For every profit level X, Vv(X) has a solution t* with the following properties:
1) t* is non-decreasing,
2) there exists s* G [0, x] such that {t* = 0} = [0, s*] and t* is 1-Lipschitz in
(s*,x).
3) Every solution ofVy(X) satisfies conditions 1) and 2).
Let us consider now some examples.
Example 1 The insured is a RDEU maximizer
Let us recall that a RDEU agent is characterized by an increasing utility index

U : R ?> R and an increasing probability perception function / : [0,1] -> [0,1]
that satisfies /(0) = 0, /(l) = 1. The overall utility function is then defined by :
/O /?+00
[f(?({U(Y) > <})) - l]dt + / M{U(Y) > t}))dt

-oo JO
We recall that a RDEU maximizer is strongly risk averse iff J is concave and /
is convex. Furthermore if U is strictly concave or / strictly convex then the agent
is strictly strongly risk averse (see Chew et al. [7]). Let us assume then that U is
increasing and strictly concave and that / is increasing and convex so that V fulfills
(Ul) and (U3).
Furthermore, if Yn is a bounded sequence of L?? such that Yn converges to Y
in L1, then U(Yn) converges to U(Y) in probability, hence in distribution. Hence
p({U(Yn) > t} -? p({U(Y) > t} for almost every t. This implies by Lebesgue's
Dominated Convergence Theorem that V(Yn) ?> V(Y) and that V satisfies (U2).
Example 2 Implicit weighted utility
Let H be an interval of R and D(H) be the set of probability distribution func

tions on H. Let us recall that a preference relation on D(H) satisfies "betweeness"
if the preference for a probability mixture of 2 lotteries is intermediate between
the preference for the respective lotteries. A betweeness-conforming utility V(Y)
called "implicit weighted utility" is given by the solution in s of :
&y(s) = /
Jhip(x,s)dFY(x) = 0
where Fy is the distribution function of Y, dFy the associated (Stieljes) measure
and <?>:??xR-?Risa continuous function that satisfies the following :
a) For all x G H, (p(x, ) is decreasing.
b) There exists M > 0 such that for all x G H
s> M => (f(x,s) < 0

s < -M => <p(x,s) > 0.
c) For every s G R, y?(., s) is increasing and strictly concave.
It follows from these assumptions that for every Y G L??, #y is a well-defined

continuous decreasing function and that there exists a unique root for the equation
&Y = 0, by definition V(Y) is this root. Note also that assumption b) ensures
\V(Y)\ < M since VY(M) < 0 and $Y(-M) > 0.
Since (p(., s) is increasing, for all a > 0, #V+a > ?V which implies that
V(Y + a) > V(Y) and (Ul) is fulfilled.
If X y2 Y, then &x > #y since <p(., s) is strictly concave increasing. This
implies that V(X) > V(Y) so that V satisfies (U3).
Lastly, if Yn converges to Y in L1, then dFyn converges to dFy in the weak-*
topology, hence #yn converges to ?V pointwise since </? is continuous in x. As
#Yn and #y are decreasing, it follows from Dini's Theorem that the convergence
is uniform on the compact set [-M,M]. Since by definition &Xn(V(Xn)) =
WX(V(X)) = 0 there is no difficulty in proving that V(Xn) -> V(X). Hence V
satisfies (U2).
6 Insurance fraud
We assume that the magnitude of the loss x is private information known only by
the insured. The magnitude of the loss may be observed by the insurer through
a costly verification. We restrict our study to the case of deterministic auditing
policies (for random auditing, the reader is referred to Fagart and Picard [11]).
We define therefore a verification set M C [0, x] over which auditing occurs. An
insured who experiences a loss x may choose to misrepresent it by claiming x where
i/x. There are two cases : either x G M, then the claim is audited, the real loss
x is observed and the insured receives t(x) (there is no penalty when an insured
is caught cheating), or x G Mc, then the claim is not audited and the insured gets
t(x).
Contracts are therefore characterized by a triple (t, P, M) where t is the indem
nity schedule, P the premium and M the verification set.
We assume that there is a fixed audit cost c\ for the insurer. The cost of re
imbursement, independent of the audit structure, is given by a function c(.), con
tinuous, convex, increasing and C1 on R+. A non-convexity arises here from the
introduction of the fixed cost c\.
Definition 4 A contract (t, P, M) is incentive compatible if the insured truthfully

reveals his actual loss, i.e. ifx = x is an optimal strategy for him:
V(x, xf) e [0, x] x Mc, U(-P-x + t(x)) > U(-P -x + t(x'))

Assuming that, for each contract, there exists an optimal strategy, to be im
plementable, incentive compatible contracts must satisfy the following condition :
there exists to G R+ such that,
t(x) = t0, \/x e Mc
t(x) > t0, \/x e M
In other words, to obtain a truthful revelation, a constant indemnity must be

paid on the non-auditing set.
As proved by Picard [15], any contract for which there exists an optimal strategy
is weakly dominated by an incentive compatible contract. So we may restrict our
study to incentive compatible contracts, that we shall from now on identify with
triples (t,P,to).
In order to apply the results of the previous sections, we introduce an additional
technical constraint :
Definition 5 A contract (t, P, to) is feasible if and only if it is incentive-compatible

and satisfies, for all x G [0, se], t0 < t(x) < x A- to
Remark. The constant t0 may be viewed as an informational rent given to the insured
who have hidden knowledge about their loss.
Since M = {x : t(x) > t0}, a contract is defined here by the triple (t, P, t0).
The insured's indirect utility v(t, P, to) may be expressed as follows :
v(t,P,t0)= IJm
U(-P-xA-t(x))dp(x)A-
Jmc / U(-P~xA-t0)dp(x)
while the profit of the insurer n(t,P,
ir(t,P,t0) = P- [Jm
[c(t(x)) A-c1]dp(x)
Jmc - I c(t0)dp(x)
Definition 6 A contract (t,P,to) is Pareto

(t', P', tf0) such that v(t(, P', Q > v(t, P
least one strict inequality.
Let us now prove that, without loss o

indemnity is paid on the non-auditing set
Proposition 3 Assume that c'(0+) > 1 (r

ble contract (t, P, to) is weakly dominated
contract (t ? to, P ? to, 0)
Proof. Assume that n(t, P, to) ? X for
P = / [c(t(x)) A- c1}dp(x) +
Jt>t0 Jt=t0
As c(t) >t,Vt>0,P> t0. Assume t0 > 0. Let h > 0 be such that t0 - h > 0,
then
Av =v(t-h,P-h,t0-h)-v(t,P,t0) =0
An = n(t-h,P- h, tQ - h) - n(t, P, t0)
= -h + / [c(t(x)) - c(t(x) - h)]dp(x)

Jt>t0
+ /Jt=t0
[c(t0) - c(t0 - h)]dp(x)
> -h + cf(t0-h)h( [ dp(x)
\Jt>t0
+ /Jt=t0
dp(x)) = h(c'(to
) - h) - 1) > 0,
since cf is increasing and c'(0+) > 1. The inequality is strict if c7(0+) > 1. D
Hence we shall now on assume that t0 = 0. A contract is therefore defined by

the pair (t, P). The profit of the insurer may be written
7t(t,P) = 7r(t,P,0) = P / [c(t(x)) + c1l{t>0}(t(x))]dp(x)

Jo
= P - /Jqc(t(x))dp(x)
where c is defined by :
c(0) = c(0)
c(t) = a + c(t) Vi > o
and the insured's utility by v(t, P) = v(t, P, 0). Then the search for Pareto-optima
may be expressed as follows:
( sup v(t,P)
t(.),p
(Vi){ s.t. 0 < t(x) < x a.e. in [0, x]
?(t,P) = X
where A is the level of benefit of the insurer.
We may therefore apply the results of Section 3. They are summarized in the
following proposition:
Proposition 4 There exist Pareto efficient incentive-compatible contracts. Any such

contract t is such that:
1. the non-verification set is a set of low realizations of the loss, Mc = {t ? 0} =
2. t is non-decreasing and 1-Lipschitz on the verification set M = (so, x],

3. t has at most one jump and, if0<so<x, then t has a jump at sq.
Other information structures may be considered. Let us first assume that if

x e [0,x] is the loss and the agent declares xf < x, then the auditor cannot check that
the true loss was x and therefore the agent receives t(xf). Then incentive compatible
contracts have to be non-decreasing in the level of the damage. It follows from
Section 4 that efficient contracts compatible with this new information structure
remain unchanged. Furthermore, it is not costly for the auditor to be unable to
check that an insured underdeclares his loss. On the other hand, if the no-sabotage
constraint is added, then incentive compatible contracts have to be non-decreasing
in the damage and such that agents' wealths are non increasing in the damage. It
also follows from Section 4 that efficient contracts are continuous. Hence efficient
contracts are affected by this new information structure, in other words the no
sabotage condition is costly for the insurer.
Appendix
Proof of Lemma 1
Let us show that J(to) > J(t) for any measurable contract t. Let t be a measurable
contract satisfying 0 < t(x) < x and let P = XA-JQc(t(x))dp(x) be the associated
premium. Let us prove that there exist continuous contracts (t?)?>o,0 < t?(x) < x,
such that J(t?) ? J(t) as e -^ 0 and 7r(t?,P?) = A. By Lusin's Theorem (see
for instance [19]), for all e > 0 there exists te which is continuous and such
that p({I ^ I?}) < e. Moreover t? can be chosen such that 0 < t? < x. Let
P? := A + jQ c(t?(x))dp(x). We first have :
\P-P?\< / \c(t) - c(t?)\dp < ae
for some a > 0, since t and t? are bounded by x. Moreover
\J(t) - J(t?)\J{t&e}
< [ \U(-x + t - X - P) - U(-x + t?-X- P?)\dp
+ /J{t=t?}
\U(-x A-t-X-P)- U(-x A-t-X- P?)\dp
Since the integrand is bounded in the first integral, there is a constant C2 such that the
first integral is less than C25. Since U is locally Lipschitz and \P?P? \ < C\S, there
is a constant C3 such that the second integral is less than C%e. Hence J(t?) -> J(t)
as t? - t. As J(to) > J(t?)yt?, passing to the limit, we get
J(to) > J(t)
which ends the proof.
Proof of Lemma 2
Since Jn is upper semi continuous and the set on which we optimize is compact,
Vn has a solution t = (ti,...tn).
Assume that the first assertion is not satisfied. Then there exist i and j such that
i > j and tj > U > 0. Let e > 0 be such that tj >U+ 2e. As Xj < Xi, tj ? Xj >
U ? Xi + 2e. Let t be defined by U=ti+ e, tj ?tj?e and tk = tk for k ? {i, j}.
As 0 < tk < Xk for all k, t is feasible. Furthermore:
= ?[(c(ti + e) - c{U)) - (dtj) - cfe - ?))] < 0
since c is convex and U -f- e < tj ? e. Hence
Jn(t) - Jn(t) = ~[(U(-Xi + U + e-X-P)- U(~Xi + U-X-P))

-(U(-Xj +tj -X-P)- U(-Xj +tj-e-X- P))}
> - [(U(-Xi + ti + e-\-P)- U(-Xi + U-X-P))
-(U(-Xj +tj-X-P)- U(-Xj +tj-e-X- P))] > 0
since ti + e < tj - e and U is strictly concave.
The proof of statement 2) is similar and therefore left to the reader.
It remains to prove assertion 3). Define:
jo := max{j such that tj =0}
Clearly {i : ti ? 0} C {0,..., jo}- If the inclusion is strict, then there exists j < jo
such that tj > 0. Let t be obtained from t by permuting the values tj and tj0. As
tj = tj0 ? 0 < xj and tj0 = tj < Xj < Xj0, t is feasible and
n n
Hence
Jn(t) - Jn(t) = lW(-Xjo +tj-X-P)- U(-Xjo -X-P))

-(U(-Xj + tj-\-P)- U(-Xj - A - P))\ > 0
since Xj0 > Xj and U is strictly concave.
Proof of Theorem 1
Step 1. We first provide a sequence of discretizations of the problem and find a

converging subsequence of their solutions.
For all n G N*, let (xn,i) with xn$ = 0 < xn?... < xn^n = x be a
subdivision of [0, x], satisfying:
M(?n,t) = p(Gn,j) for all (?, j) G {1,.., Nn - l}2
withi?n,i := [xn?,xn?+i), i = 0,...,Nn - 1,
lim max (xn?+i - xnA = 0

n i=0,...,iVn-l
and such that for all n G N* and all i e {0,..., Nn - 1}
there exists j G {0,.., iVn+i ? 1}, such that flnj? D f2n+i?.

Let
Nn-1
i=0
so that the sequence In converges uniformly to the identity function.

Let Vn denote the finite-dimensional problem:
\SnP{tni,i=l,...,Nn-l)Jn(tn,i) := / i^Wnftn,* ))d/i

TV s.t.' ' JO
[ 0 < *n,t < ^n,i for all ? = 1,..., Nn - 1,

where tn 0 = 0 and:
Nn-1 Nn-1
Wn(tn?)
i=0 n :=
3=0-In A-
Let (tni), i = 1,..., Nn - 1 be a solu
Nn-1
i=0
It follows from Lemma 2, that there exists a non-decreasing function Tn: [0

[0, x] and sn G [0, x] such that, tn ? Tn o Jn, Tn = 0 on [0, sn] and Tn is po
and 1-Lipschitz on (sn, x].
Without loss of generality, from Helly's selection Theorem, we may assum
Tn converges pointwise to a non-decreasing function t* and we may also as
that sn converges to s* G [0, x]. Clearly t* = 0 on [0, s*) and t* is 1-Lipsch
(s*, x\. Let us also assume that t*(s*) ? 0.
Let us now show that tn converges pointwise to t* except possibly at s*. I
tn(x) - t*(x) = Tn(In(x)) - Tn(x) + Tn(x) - t*(x)
By construction Tn(x) ? t*(x) ?> 0 for all x G [0,x]. To study the first term, let
us distinguish 2 cases: if x < s* = limn sn, then for n large enough Tn(In(x)) ?
Tn(x) = 0. If x > s*, for n large enough x > sn and In(x) > sn, hence
\Tn(In(x)) ? Tn(x)\ < \In(%) ? x\ ?y 0 since In converges uniformly to the
identity.
Step 2. We next discretize any continuous contract in such a way that the sequence
of discretized costs converge to the cost of the initial contract.
Let t be a continuous contract with 0 < t(x) < x for all x G [0, x]. Define for
all n:
Nn-1
tn :~ / ^ t"n,i*-Qni
i=0
where the tn/s are chosen in the following way:
_ f t(xn?) if t > 0 on Qn?,

n'* " \ 0 otherwise
By Heine's Theorem, tn converges to t uniformly on [0,x], By construction,
{tn+i = 0} C {tn = 0} for all n. On the other hand {* = 0} C {tn = 0}
for all neW and {t = 0} = nn N*{tn = 0} for if x G nn(EN*{tn = 0}.
Indeed, by construction, there exists a sequence xn such that xn converges to x and
t(xn) ? 0 for all neW. Since t is continuous, t(x) = 0. Hence
M({*n = 0})->/i({t = 0}). (10)
As c(t) = c\(t) + c(0+)(l ? l{t=o}) with ci continuous, we get:
IJo
c{tn)dn-?
Jo \ c(t)dfi (11)
Using (11) and Lebesgue's dominated convergenc
limJ(tn) = J(t). (12)

n
Step 3. We prove that t * is efficient. By Lemma 1, i

any continuous contract t. By definition of ?*,
Jn{t*n) > Jn(tn)
with tn constructed in step 2. As
\Jn(tn)~J(tn)\< [ \U(~In(x) + tn(x) - X - J c(tn)dp)

-U(-x H- tn(x) - A - J c(tn)dp)\dp(x)
and ?7 is locally Lipschitz and In converges uniformly to the identity function, we

get
lim[Jn(tn) - J(tn)) = 0
and similarly
lim[Jn(C)
n - J(C)] = 0.
As c is lower semi-continuous, it follows from
Rm?Jn(i;) = ??^?J(t*n) < J(t
To sum up, we have proved that
J(t*) > hm?Jn(i?)

n n> lim Jn(t*n) = lim
Hence t* dom
satisfies the fi
Proof of Lem
First note tha

be the corresp
1) Assume th
Theorem ther
continuous o
p(Kx) = p
?>0on#i (15)
and there exists e > 0 such that
inf?>sup? + 2? (16)
so that, using (14), we have
inf (t(x2)-x2) >sup(i(xi)
Let t = ? on [0, x] \ (Kx U K2), t = t

that 0 < t(x) < x and that {t>0} = {
Defining P := /* c(t(x))dp(x) and
since
r* ~
P-P>
Jo
c'(t(x))(t-t)(x)dp(x)
= e[ Jk2
cf(t(x))dp(x)
Jkx - / cf(t(x))dp(x)
> ep(Ki)[m\nc'(t
Ko. K\ - e) - maxc'(t + e)] >
where the last inequality is obtained by using (14), (16) and the convexity of c.
Furthermore
J(t) - J(t) > Jo

[ [U(-x A- t(x) - P) - U(-x A- t(x) - P)]dp(x)
>
[ [U'(-x + t(x) - P)(t- t)(x)]dp(x)
Jo
> ?//(#!)[min U'(-xA- t(x) A- s
- max U'(-x A- t(x) - e - P)}

>0
since (17) is fulfilled and U' is decreasing, contradicting the o

CPo).
The proof of 2) is similar and is therefore left to the reader.
Proof of Lemma 4
The proof of 1) is rather standard and a proof can be found in [5]. To prove 2), let
us introduce the two functions t\ and t2 defined as follows:
t$x) := sup ?a(s), for all x G [0,x], (18)

s?A, s<x
t2(x) := ?i(x) if x <? A, t2(x) = t(x) if x G A. (19)

Note that t\ is non-decreasing and t\ = tA on A. We shall prove that t\ is the
non-decreasing rearrangement of t2. Indeed, let / be measurable, we have
f f(t2(x))dp(x) = JO
/ f(t(x))dp(x)
JA J[0,x]\A+ / f(t1(x))dp(x)
as:
/ JA
f(t(x))dp(x) =JA
/ f(tA(x))dp(x)
JA = / f(h(x))dp(x)
we obtain that ?i and
/ L(x,tA(x))d
Ja Ja
px px
= / L(x,t2(x))d
Jo Jo
using (7) we exactly obtain (8). M
t2 =t2= t\ i.e. t ? tA
Proof of Proposition I
Assume that t is a solution of V(X) and t is not non-decreasing. By Lemma 3, we

already know that t is non-decreasing on {t > 0}, hence there exist two compact
subsets of [0, x), K\ and K2 such that p(K$ = p(K2) > 0, and
sup#i < inf K2, t = 0 on K2, t > 0 on Kx. (20)

By Lemma 3, t is non-decreasing on K\.
Define A := K\ U K2 and let tA be the non-decreasing rearrangement of t with
respect to A.
Define then t*(x) = tA(x) if x e A, t*(x) = t(x) otherwise. First it is clear
that//({?^?*}) >0.
Let us prove that t* is admissible i.e. 0 < t* (x) < x. There is obviously nothing
to prove ifx^A and it is clear that t* > 0. If x G K\ we have t*(x) ?tA(x) =0
and if x G K2, there exists y e K\ such that t*(x) ? t(y) < y and since y < x,
we deduce that t* is admissible.
Let us show now that J(t*) > J(t). We first have
P:= / Jo
c(t)dp=
Jo/ c(t*)dp.
As
J(t*)-J(t)= / Ja
U(-x + tA(x) + a)d[jL(x)
LU(-x + t(x) + a)dp(x) (21)

with a = -(A + P), 2) of Lemma 4 and (21) exactly yield J(t*) > J(t) contra
dicting the optimality of t.
Proof of Proposition 2
Let us show that t(s??_) > 0.

Assume on the contrary that t(s+) = 0. We have t > 0 on ($*,#], and ? is
1-Lipschitz on (s*,x]. Let ? > 0 be such that
s? := inf {x > s* such that t(x) > s} < x
and let t? by t? = 0 in [5*, se] and ?e = ? in [0, x] \ [s*, se]. Consider also the
associated premiums:
Pe = X -h /Jo
c(t?)d/i < PJo
:= X + / c(i)d/i
= P?+ [?J s*Cl(t)dp + c(0+)p([s?,s*])

We thus have
P-Pe>c(0+))/i([se,s*])
There exists then two positive constants a\ and a2 such that:
For all x G [s*,se],
U(-x + t?(x) -X-P?)- U(-x + t(x) -X-P)

> U(-x -X-P)- U(-x A- t(x) -X-P)> -axe (22)
For all x G [0,x] \ [s*,se],
U(-x A-t?(x)-X- P?) - U(-x A- t(x) -X-P)> a2.p([s*, s?]) (23)

It follows from (22) and (23) that
J(te) - J(t) > v([s*, s?])(-ai.e + a2.(l - p([s*,s?])))
For e > 0 small enough, J(t?) > J(t), contradicting the efficiency of t.
Proof of Theorem 5
1) Let us first remark that since V fullfills (U2), the construction of Lemma 1 which
is based on Lusin's theorem extends to the case of non separable utilities.
2) Let us prove a generalization of Lemma 2. Let 0 = xo < x\ < ...xn_i <
xn ? x be a subdivision of [0,x] such that ??([x?,x?+i)) = ?, ? = l,...,n-l.
and consider the problem:
{SUP(tl,...,tn) Jv(tl,-.;tn) = V(W(t1,...,tn))

s.t.
0 < U < Xi for all ? = 1,..., n
with to = 0 and
n? 1 -, n
W(h, ...,tn) := J2 l[x^xw)(-Xi + U-X-~Y^ c(*j))

i=0 j=l
Since Jy is upper se
Vnv has a solution (
Lemma 2.
Assume that the first assertion of Lemma 2 is not satisfied. Then there exist i
and j such that i > j and t3- > U > 0. Let e > 0 be such that t3- > U A- 2e. As
Xj < Xi, tj ? Xj > ti ? Xi A- 2e. Let t be defined by U = U A- e, tj = tj ? e
and tk = tk for k ^ {?, j}. We have, as in the proof of Lemma 2, for any strictly
concave utility index U,
E(U(W(t1,...,tn)))-E(U(W(t1,...,tn)))>0
892 G. Cartier and R.-A. Dana
Hence W(t\,..., tn) y2 W(t\,..., tn), therefore, using (U3), we get
Jv(tu-Jn) - Jv(h,...,*?) = V(W(tU...,tn)) - V(W(h,...,tn)) > 0

which contradicts the optimality of(ti,..,tn). The proof of statements 2) and 3) of
Lemma 2 are similar and therefore left to the reader.
We then introduce a sequence of discretized problems exactly as in Step 1 of
Theorem 1 and find a converging subsequence of their (step-functions) solutions.
Let t* denote the pointwise limit of those step-functions, as in the proof of Theorem
1, t* satisfies the statements of Theorem 5.
Then we discretize any contract t by a sequence (tn) of step-functions exactly
as in Step 2 of Theorem 1. Since (tn) converges uniformly to t, since (11) is satis
fied and since V fullfills (U2), we obtain Jy(tn) ?> Jy(t). Finally the conclusion
of Step 3 follows from (Ul), (U2) and the upper-semicontinuity of Jy. We get
then Jy(t*) > Jy(t) for every continuous t and using 1), we deduce that t* is
Pareto-efficient.
3) The proof of Lemma 3 extends to the non expected utility-case, hence every
solution of Vy satisfies the statements of this Lemma. To end the proof of the
Theorem, it is enough to show that Proposition 1 holds true. As in the proof of
Proposition 1, assume that t satisfies the statements of Lemma 3 and t is not non
decreasing. As in the proof of Proposition 1, we may then find an admissible contract
t* such that
E[U(W(t*)] > E[U(W(t)}
where
W(t)(x):=-x + t(x)-X- /inc(t(s))dp(s)

and
W(t*)(x) := -x + t*(x) - X -Jn
[ c(t*(s))dp(s)
for every strictly concave increasing utility function U of class C1. Using Remark
5, we obtain that Jy(t*) > Jy(t), hence a contradiction.
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Pareto Efficient Insurance Contracts When the Insurer's Cost Function Is Discontinuous

Author(s): Guillaume Carlier and Rose-Anne Dana

Pareto efficient insurance contracts

Received: November 8, 2000; revised version: March 12, 2002

Keywords and Phrases: Efficient insurance contracts, Discontinuous cost func

JEL Classification Numbers: C61, G22.

Correspondence to: R.-A. Dana

- there is no verification and no indemnity,

The paper is organized as follows. In Section 2, we recall Gollier's model.

W(X) :=w0-P-X + t(X) (1)

n(t, P):=P- /Joc(t(x))dp(x)

Definition 1 1) A contract (t, P) is Pareto efficient iff there exists no contract

As usual, we may parametrize Pareto efficient contracts by the profit level A of

3 Pareto efficient contracts

3.1 Existence of Pareto-efficient con

From now on, we shall associate to t

We next study a discretization of V(X), corresponding to the case where there

Jn(*l,...,*n) := - Y] U(-Xi + U - X-Y]c(tj))

Lemma 2 Vn has a sol

3) With the conventi

Using the previous lem

Theorem 1 For every

3.2 Characterization of efficient contracts

Lemma 3 Ift is a solution ofV(X), then:

To prove that efficient contracts are non-decreasing it remains to be shown

p({t< a}) = p({t < a}), for all a G [0,x\. (2)

The function t is called the non-decreasin

p({tA < o?} H A) = p({t <a}n

We then have the following rearrangement inequalities which are an importan

Lemma 4 1) Let t: [0,x] -> [0,x] be a p-measurable function and let t be t

Since U is of class C1, L(t, x

Finally we prove that the discont

Proposition 2 Ift is a solution

0 < 5* := inf{x G [0,x

It follows from the previous pr

Theorem 2 For every profit le

4 Variants of the model

As we shall see in Section 6, in applications, insurance contracts are restricted to

Theorem 3 A contract is Pareto efficient if and only if it is X-Pareto efficient.

Proof. Assume that t is Pareto-efficient. From Theorem 2, t is non-decreasing,

S = {t : [0, x] -> R such that t and Id ? t are non-decreasing}

A contract in S is called an S contract. S is the class of contracts for which the

Definition 3 AS contract (t, P) is S-Pareto efficient iff there exists no S contract

Theorem 4 1) There exist S-Pareto efficient contracts.

d := ini{x G [0,x] such that t*(x) > 0}.

5 More general utility functions

In Section 3, we have made extensive use of stochastic dominance arguments. Let

Remark. Strong risk aversion does not imply concavity or quasi-concavity of V.

{sup Jv(t) := V(-x + t(x) - X - ?n c(t(s))dp(s))

Theorem 5 Assume that V satisfies (Ul), (U2) and (U3), then :

Let us consider now some examples.

Example 1 The insured is a RDEU maximizer

Let us recall that a RDEU agent is characterized by an increasing utility index

[f(?({U(Y) > <})) - l]dt + / M{U(Y) > t}))dt

Example 2 Implicit weighted utility

Let H be an interval of R and D(H) be the set of probability distribution func

s> M => (f(x,s) < 0

It follows from these assumptions that for every Y G L??, #y is a well-defined

Definition 4 A contract (t, P, M) is incentive compatible if the insured truthfully

Jn(l,...,n) := - Y] U(-Xi + U - X-Y]c(tj))

tn(x) - t(x) = Tn(In(x)) - Tn(x) + Tn(x) - t(x)

= P?+ [?J sCl(t)dp + c(0+)p([s?,s])