Optimal long-term contracts with disability insurance under limited commitment

We study an optimal long-term labor contract that provides disability insurance benefits under two frictions: the agent cannot commit to a long-term contract and the disability shock is private information. We predict that a job with a high risk of disability should provide a higher level of salary...

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Bibliographic Details
Published in:Insurance, mathematics & economics mathematics & economics, 2022-05, Vol.104, p.99-132
Main Authors: Choi, Kyoung Jin, Jeon, Junkee, Lee, Ho-Seok, Lin, Hsuan-Chih
Format: Article
Language:English
Subjects:
Contracts
Cost analysis
Disability
Disability insurance
Dynamic contracting
Growth rate
High risk
Incentives
Insurance
Insurance policies
Labor contracts
Limited commitment
Quantitative analysis
Trading
Truth-telling
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Summary:We study an optimal long-term labor contract that provides disability insurance benefits under two frictions: the agent cannot commit to a long-term contract and the disability shock is private information. We predict that a job with a high risk of disability should provide a higher level of salary but with a lower growth rate over time. We find that the optimal contract can be implemented under a three-account trading system in which mandatory savings can be imposed to discourage a worker from falsely claiming disability. We also investigate how the nature of disability shock has an impact on the optimal contract: a larger borrowing limit should be given to a worker with a high severity of the disability shock or a low arrival intensity. Finally, our quantitative analysis shows that the cost caused by current long-term disability insurance practice can be substantial.
ISSN:0167-6687
1873-5959
DOI:10.1016/j.insmatheco.2022.02.007