Pareto-optimal insurance with an upper limit on the insurer's exposure

Abstract

We examine the problem of determining Pareto-optimal (PO) insurance contracts when the insurer imposes an ex ante upper limit on disbursement. The problem is similar in spirit to that of Cummins & Mahul (2004), but it extends it in two directions: first, we use the more general and more flexible class of distortion premium principles; and second, we allow for heterogeneity in beliefs between the insurer and the insured. We unify the settings of Ghossoub (2019a, 2019b), and we adapt the approaches therein to encompass the case of a policy limit. First, we show that PO contracts are those that result from a budget-constrained optimization problem for the DM. We then provide a closed-form characterization of optimal contracts. Our result is similar in spirit to that of Cummins & Mahul (2004), who show that when policy limits are introduced to Arrow's model, PO contracts are limited deductible contracts. While Ghossoub (2019a, 2019b) shows that variable deductible contracts are optimal, the results of the present paper indicate that limited variable deductible contracts are optimal when policy limits are present. We illustrate our results via numerical examples.