The name is absent

CFS Working Paper No. 2005/24

Insuring the Uninsurable:

Brokers and Incomplete Insurance Contracts*

Neil A. Doherty¹ and Alexander Muermann²

September 2005

Abstract:

How do markets spread risk when events are unknown or unknowable and where not
anticipated in an insurance contract? While the policyholder can “hold up” the insurer for extra
contractual payments, the continuing gains from trade on a single contract are often too small
to yield useful coverage. By acting as a repository of the reputations of the parties, we show
the brokers provide a coordinating mechanism to leverage the collective hold up power of
policyholders. This extends both the degree of implicit and explicit coverage. The role is
reflected in the terms of broker engagement, specifically in the ownership by the broker of the
renewal rights. Finally, we argue that brokers can be motivated to play this role when they
receive commissions that are contingent on insurer profits. This last feature questions a recent,
well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer.

JEL Classification: G22, G24, L14

Keywords: Incomplete Insurance Contracts, Brokerage, Contingent Commissions, Reputation

* We wish to thank Christian Laux, Georg Noeldeke, Soenje Reiche and seminar participants at the Risk Theory Society
meeting 2005 and the Center for Financial Studies for valuable comments.

¹ Department of Insurance and Risk Management, The Wharton School, University of Pennsylvania, 3620 Locust Walk,
Philadelphia, PA 19104-6302, USA, email: [email protected]

² Department of Insurance and Risk Management, The Wharton School, University of Pennsylvania, 3620 Locust Walk,
Philadelphia, PA 19104-6302, USA, email: [email protected].

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