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Authors:

• Hanming FANG
  Duke University

• Edward KUNG
  Duke University

We study the effect of life settlement market on the structure of the long-term contracts offered by the primary insurance market, as well as on the consumer welfare in a dynamic model of insurance with one-sided commitment as in Hendel and Lizzeri (2003) and Daily, Hendel and Lizzeri (2008). We show that the presence of the settlement market affects the extent as well as the form of dynamic reclassification risk insurance in the equilibrium of the primary insurance market; and that the settlement market generally leads to lower consumer welfare. In the most extreme form, the presence of the settlement market can completely unravel the dynamic contracts to a sequence of spot short-term contracts. We also examine the primary insurers' response to the settlement market when they can offer enriched contracts by specifying optimally chosen cash surrender values (CSVs). We show that the option of specifying CSVs is a useless option when there is no settlement firms; but facing the threat from the settlement firms, contracts with optimally chosen health-contingent CSVs will emerge in the equilibrium of the primary market, and such contracts improve consumer welfare, even though consumer welfare is still lower than that without the secondary market. In contrast, the option to endogenously specify non-health contingent CSVs is useless for the primary insurers.