Mitigating moral hazard with usage‐based insurance

Abstract

Abstract Technological progress has improved insurers' ability to monitor policyholders and has led to usage‐based insurance (UBI) contracts that incorporate behavioral risk factors in pricing. Economic theory predicts that any informative monitoring signal is adopted in equilibrium. In practice, the demand for UBI is still low to date with market shares in the single digits. We modify the standard moral‐hazard model in insurance economics by trading off a simpler effort model for a richer strategy space, and by focusing on the use of monitoring for premium differentiation. In our model, an informative monitoring technology is in use if it is sufficiently accurate. Otherwise, the premium incentive from monitoring is not large enough to alleviate the incentive‐compatibility constraint to an extent that would make policyholders better off. Our results help explain the slow adoption of UBI contracts in practice and provide an avenue to increase their appeal to policyholders.