The Design of an Optimal Insurance Policy

Almost every phase of economic behavior is affected by uncertainty. The economic system has adapted to uncertainty by developing methods that facilitate the reallocation of risk among individuals and firms. The most apparent and familiar form for shifting risks is the ordinary insurance policy. Previous insurance decision analyses can be divided into those in which the insurance policy was exogenously specified (see John Gould, Jan Mossin, and Vernon Smith), and those in which it was not (see Karl Borch, 1960, and Kenneth Arrow, 1971, 1973). In this paper, the pioneering work of Borch and Arrow—the derivation of the optimal insurance contract form from the model—is synthesized and extended.