Repeated Insurance Contracts and Moral Hazard* ARIEL RUBINSTEIN AND MENAHEM

In this essay, we shall make an attempt to account for the frequently observed phenomenon of insurance companies offering discounts to clients who possess a favorable record of past claims. We shall argue that such discounts provide a mechanism which enables both insurer and insured to counteract the inefficiency which arises from moral hazard. Moral hazard is an example of economic interaction involving imperfect observability: The insurer cannot observe certain actions taken by the insured, actions which, however, have an effect upon the insurer’s payoff. Moreover, this inability of the insurer to observe the actions of the insured creates an incentive for the insured, once insurance is purchased. to act in a manner that is liable to enhance the likelihood of a large claim being filed. As a result, the scope for a mutually advantageous interaction becomes severely hampered and, in particular, fully efficient interaction becomes impossible because efficient contracts are not enforceable. If interaction takes the form of an isolated contract, then any attempt to correct the inefficiency caused by moral hazard must take place through the specification of what rewards or penalties the insured person would incur for any given level of the commonly observable variables. Much of the literature on moral hazard to date has concentrated on the question of how to design a