The Optimal Insurance Contract with Tax Deductions

We examine the impact of tax deductions on optimal insurance contracts. We find that, under a proportional tax deduction system, a nonzero deductible is obtained even though there are no variable costs for the insurer. On the other hand, the optimal coinsurance rate would remain at unity, even under the tax deduction system, when the insurer is risk neutral. A policy with an upper limit cannot be the optimal contract, no matter what tax deductions are provided for losses. Furthermore, unlike Kaplow’s (1992) finding that tax deductions reduce an individual’s demand for coinsurance, our results show that the implementation of tax deductions increases the deductible but may or may not decrease the coinsurance.