Hardball and the soft touch: The economics of optimal insurance contracts with costly state verification and endogenous monitoring costs

We examine an environment of costly state verification in which insureds possess private information about the magnitude of an insurable loss. Insurers can verify the actual loss suffered only by incurring a positive resource cost, and insureds may engage in evasive activities that, while privately costly, increase the costs of verification and may lead to more generous settlements. Optimal insurance contracts are shown to mitigate the incentives to evade by a combination of incentives, which include the overpayment of easily monitored losses and undercompensation for claims exhibiting higher verification costs.