Is Honesty the Best Policy? Curtailing Insurance Fraud through Optimal Incentive Contracts

An incentive contracting approach is used to characterize optimal contracts when insured individuals possess private information about their losses and are able to misrepresent permanently their loss magnitudes by engaging in the falsification of claims. We demonstrate that efficient agreements necessarily induce some falsification but that the extent of such claims inflation is mitigated partially by an indemnification schedule that overcompensates small losses while overpaying larger ones. The differential costs of generating insurance claims through falsification provide an avenue by which the heterogencous insureds can credibly signal their underlying losses and are exploited in an optimal contract to implement loss‐contingent insurance payments.