partners (e.g. Rubinstein and Wolinsky, 1987) and information intermediaries who are able to transmit
credible information and thereby lower costs of adverse selection (Biglaiser, 1993). In addition to these
roles, we show that brokers act as a clearing house of the reputations of insurers. This role enables
brokers to “hold up” insurers for ex post reasonable transfers for non verifiable losses. Given appropriate
compensation, brokers can exercise a credible threat to insurers which leads to more complete insurance
markets. Our work parallels that of Kingston (2005) who shows that brokers can help sustain cooperation
in markets where lack of trust can lead to a prisoner’s dilemma in which parties default on their trades. This
examination of brokers is topical. Brokers have been assailed recently by the New York attorney general,
Elliot Spitzer, and at the center of this assault is the compensation structure for brokers. Contrary to
Spitzer’s assertions, we will show that the compensation structures criticized by Spitzer, can lead to real
benefit to policyholders.
1.1 Non-Verifiable Losses
At the heart of our paper are non-verifiable or non-contractible events. By these we mean events that are
incapable of inclusion in the policy because they can not be anticipated; or events which are simply too
complex to include in the contract, or events or circumstances which could be included but, due to time
inconsistency or the prospect of new information, the parties believe it preferable to bargain after the fact.3
Non-verifiable losses can also refer to the size or cause of the loss. An insurance policy might be specific
about how a claim is to be settled (damage to a home or its contents might be limited to the repair cost
or the cost of replacement with something of similar condition), but the insurer and insured might wish to
leave open the possibility that settlement can be more generous as idiosyncratic circumstances dictate, or
less generous if there is suspicion of claim fraud (which is difficult to prove).
Consider unanticipated losses. The parties consider the possibility that some unanticipated losses might
occur. These unanticipated losses are not insurable in a formal contract because they cannot be specified
and, even if they could be specified, they might be unsuited to insurance perhaps because they would
incite severe ex post moral hazard, or because they are undiversifiable. However, there is another class of
unanticipated losses for which, had they been anticipated, the parties would concur that they are insurable.
3 Some policies specify the perils and losses that are covered. If a loss occurs that is not specified, then it is not covered.
Other policies work in the opposite direction, they cover everything that is not included. The latter does provide a structure
for including the unanticipated, but does so at a cost — it is open ended and becomes very difficult to price. Moreover, having
such open policies complicates the insurer’s financial and risk management.