1 Introduction
Our ob jective is to show how insurance markets can provide an orderly mechanism by which policyholders
can receive transfers for losses that are non verifiable and, possibly were never anticipated when coverage was
written. Given the pace of technical, social and legal change, such fuzzy risks are cropping up with some
frequency. Examples include the asbestos claims that have cost the insurance industry tens of billions of
dollars, the sudden appearance of toxic mold in insurer claims, various forms of "cyber loss", and possibly the
9/11 losses which, despite the war exclusion on many policies, were not disputed by insurers and reinsurers.
We will show that brokers play a central role in extending insurance markets to cover non-verifiable losses.
A clue to the role of brokers lies in their contractual arrangement with insurers.1 It is normal for brokers
to “own the renewal rights” on the book of business they place with the insurer. This means that the
broker has the renewal rights to the policies it places with that insurer. The broker is free to recommend
to its clients that they renew with the current insurer or switch to a rival. Contrary, the insurer revokes
any right to direct solicitation of business places through the broker. This provision vests the broker with
considerable hold up power. Why would brokers seek this hold up power, how would they exercise it and
why would insurers choose to vest this power in the broker?
In our model, insurance contracts are written that cover verifiable losses. However, non verifiable losses
also can arise. Brokers then encourage insurers to make transfers for the non verifiable losses, against the
threat that the business will be withdrawn and the future rents lost to the insurer. In this way, the market
for risk transfer is extended to include losses that are not contractible. For their part, insurers are willing
to expose their reputations to this hold up threat because they can extract rents from the extended informal
coverage. For the broker’s part, they can participate in those rents and, indeed, a profit based commission
will make the threats they hold over insurers credible.2
Previous literature has stressed several roles for brokers including search agents who match trading
1 Ironically, it is the completeness of the broker-insurer contract that supports the incompleteness of the insurance contract
that we now describe.
2 Some observers have noticed a trend towards the ex post negotiation of claims. Apparently, insurers are now more likely
to dispute large claims, to offer less than 100 cents on the dollar, or to try to get away without paying. Richard and Barbara
Stewart (2001) have labeled this the "loss of certainty effect" and Kenneth Abraham (2001) has talked of the "de facto big
claims exclusion". One reason for such disputes is that large claims threaten insurer solvency and such offers may be seen to
resemble workouts in which distressed non-insurance firms negotiate with creditors. But the issue here is with the willingness,
not the ability, to pay. These writers see the "big claims exclusion" as degradation of the insurance market because risk-averse
consumers will place a lower value on such uncertain insurance. Indeed, they see a potential downward spiral of the insurance
market if this practice continues. Contrary, we argue that ex post negotiation might represent an expansion of the insurance
market to include transfer for non verifiable losses.