FEATURE ARTICLES OPTIMAL INSURANCE WITH COSTLY INTERNAL CAPITAL

We introduce costly internal capital into a standard insurancemodel, in which a risk-averse policyholder buys insurance froma risk-neutral insurerwith limited liability. The unique optimal contract and internal capital lead to a strictly positive probability for insurer default. Some risks are uninsurable in that the insurer chooses not to provide insurance against such risks. An increase in the cost of capital may lead to a higher optimal amount of internal capital. The results extend tomultiple policyholders in a symmetric setting.Our extension of the classicalmodel to include costly internal capital provides a fruitful approach to many real world insurance markets