New Publication in the Journal of Risk and Insurance

Usage-based insurance (UBI) products incorporate information about policyholders’ behavior in pricing. New technologies allow insurers to tie insurance premiums more closely to each individual’s risk level and to reward risk-reducing behavior with premium discounts. For example, telematics sensors can track the policyholder’s driving style in auto insurance, and wearable devices can record information about physical activity in health insurance.

Surprisingly, the demand for UBI policies is still comparably low, although such contracts have been available for more than two decades now. Julia Holzapfel, Richard Peter, and Andreas Richter solve this puzzle in a theoretical framework that modifies the standard moral-hazard model. They show, that in this setting, a monitoring technology will not be used unless it is sufficiently accurate.

An informative monitoring technology allows insurers to use premium discounts to incentivize prevention. This possibility relaxes the incentive-compatibility constraint because risk sharing is no longer the only way to encourage effort. As a result, policyholders benefit from higher insurance coverage compared to the case without monitoring. However, when monitoring is not sufficiently accurate, the benefit from higher insurance coverage is outweighed by the risk of being misclassified and not obtaining the premium discount. In this case, policyholders prefer the traditional moral-hazard contract, and monitoring is not part of the equilibrium.

Link to the paper: https://onlinelibrary.wiley.com/doi/10.1111/jori.12433