University of Augsburg Lilia Filipova Monitoring and Privacy in Automobile Insurance Markets with Moral Hazard ARIA August 6, 2007 Quebec City

2 Automobile insurers record data about  distance traveled  frequency of trips  when (time of the day, rush hour)  duration of trips, stopovers  where (type of road, speed limits)  speed  accelerations and braking  space measuring  usage of seatbelts  airbag-functioning  collision data  tire pressure

3 Related literature  imperfect exogenous signals:  Holmström (1979), Shavell (1979), Harris / Raviv (1979)  endogenous monitoring:  random sampling - Townsend (1979), Dye (1986), Lambert (1985)  endogenous precision of the signal - Singh (1985), Meth (1996), Kim / Suh (1992)

4 Contract schemes (1)  conditional monitoring  only the indemnities (I) depend on the monitoring signal

5 Contract schemes (2)  no restrictions on monitoring  both (B) the premiums and indemnities depend on the monitoring signal

6 General setting of the model  perfectly competitive market with risk-neutral insurers  risk-averse individuals  two possible outcomes: Loss (W-L) and No Loss (W)  two effort levels, with probabilities of NO Loss  insurance contracts  monitoring with comprehensiveness of data  individuals’ utility  with and

7 General setting of the model  monitoring technology  generates a binary signal

8 Conditional monitoring – endogenous precision (1)  maximization problem

9 without privacy costs with privacy costs  IC:  zero-profit constraint:  expected contractual utility Conditional monitoring – endogenous precision (3) with

10 without privacy costs with privacy costs  marginal effect of precision Conditional monitoring – endogenous precision (4)

11  generally, when i increases:  the signal becomes more informative of effort  incentives on effort improve  risk-sharing improves  expected contractual utility increases  privacy costs:  lead to an interior solution for i unless privacy costs increase too fast  reinforce the incentives on effort  improve the allocation of risk  increase the expected contractual utility  decrease the total expected utility Conditional monitoring – endogenous precision (6)

12 Conditional monitoring – endogenous precision ex post  precision ex post  effect is as if the level of precision was not observable  additional incentive constraint: with respect to precision  risk sharing is worse ex post flexibility of monitoring decreases the efficiency of the contract

13 Comparison of the contract schemes  without privacy costs:  Unrestricted monitoring (B) is more efficient than conditional monitoring (I) for any level of precision i.  with privacy costs:  B lacks the positive incentive and risk sharing effects of privacy costs (indirect effects)  with B the expected privacy costs are larger than with I (direct effect)  I is better than B, if -the efficiency of effort is high, -the efficiency of the monitoring technology is low, -the probability of loss is small -the privacy costs with B are large

14 Summary  without privacy costs:  B with maximum amount of data is optimal  with privacy costs:  unless privacy costs increase too fast, insureds will choose some monitoring with any contract scheme  with conditional monitoring (I) -privacy costs have an incentive and a risk sharing effect, -the expected utility of net wealth increases, -however total expected utility decreases,  I gains advantages due to direct and indirect positive effects of privacy costs.  I can be more efficient than B  ex post precision is inefficient

15 Thank you!