1.2 Examples of Incomplete Insurance Contracts
Consider the following examples of incomplete contracts. The first involves reinsurance. Traditionally, the
reinsurance market has been considered to be one based on relationships. Contracts were not very detailed
and relationships between the insurer and reinsurer tended to persist over many years. In this relationship,
the parties link their fortunes. If an unusual or uncovered loss arises, the reinsurer will often pay without
raising a fuss. But there is a corresponding obligation of “payback”. The payback feature makes the
contract something like a debt contract. Jean-Baptiste and Santomero (2000) argue that long term implicit
contracts are efficient because they allow evolving information to be included in pricing. But reinsurance
contracts may be incomplete in other ways. Contracts rarely specify the underwriting and claims settlement
practices to be adopted by the primary insurer. The reinsurer will usually monitor the relationship but
permit the primary insurer considerable flexibility in exploiting its core skills. Finally, reinsurance contracts
often are not as specific in defining coverage as are the direct policies from which they are derived. This
allows some ex post flexibility for the reinsurer to respond to losses that may not be covered. For example,
despite the war exclusion on many reinsurance policies, reinsurers uniformly responded to the 9/11 losses of
their primary insurance clients without seeking to evoke this exclusion.
The feature of the reinsurance market that is of particular interest here is the presence of brokers. If
a reinsurer behaves badly to the primary insurer, the broker will know of it. The consequence for the
reinsurer might be not only a loss of that contract, but a diversion of other business from the broker to other
reinsurers. This leveraging of reputation enhances the “hold-up” power of the primary insurer.5
The second example of contract incompleteness lies in the procedures used to inaugurate coverage in the
brokered reinsurance and high-end commercial insurance markets. Coverage is often syndicated across a
number of carriers. To set this in place, the broker approaches a number of insurers asking for a commitment
to provide coverage for a portion of the risk. To make such a commitment, the underwriter signs a binder (or
slip at Lloyds) indicating how much coverage is offered. The interesting thing about this binder is the lack
of specificity about the coverage.6 Sometimes, the binder will refer to a particular policy form indicating
5 While we are stressing the relationships in the reinsurance markets, there are signs of an apparent shift to a more com-
moditized approach, which is highlighted by, though not confined to, insurance securitization. In contrast to relationship-based
transactions, insurance securitizations are embodied in precise contractual form leaving little room for discretionary performance
and ex post bargaining.
6 In a dispute b etween the leaseholders and insurers of the World Trade Center, the central issue is whether there was one
“occurrence” or two. This is of importance because policies had not been issued at the time of the loss and coverage offered
under binders was specific enough to give p olicy limits per occurrence but not specific enough to avoid dispute as to the meaning
of “occurrence”. Had a policy been issued, then there would have probably been a precise definition of the term.