Optimal design of reinsurance contracts under adverse selection with a continuum of types

Ka Chun Cheung, Sheung Chi Phillip Yam, Fei Lung Yuen and Yiying Zhang

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Abstract: In this paper, we use the principal-agent model to study the optimal contract design in a monopolistic reinsurance market under adverse selection with a continuum of types of insurers. Instead of adopting the classical expected utility paradigm, we model the risk preference of each insurer (agent) by his Value-at-Risk at his own chosen risk tolerance level. Under information asymmetry, the reinsurer (principal) aims to maximize her expected profit by designing an optimal menu of reinsurance contracts for a continuum of insurers with hidden characteristics. The optimization problem is constrained by agents' individual compatibility and rationality constraints. By making use of the notion of indirect utility functions, the problem is completely solved for the following three commonly encountered classes of reinsurance indemnities: stop-loss, quota-share, and change loss. Some numerical examples are provided as illustrations.

Date: 2025-04
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