Balancing Transaction Costs and Risk Load in Risk Sharing Arrangement

In formulating efficient risk sharing arrangements, it is desirable to minimize both transaction costs and the risk load required by the participating insurers. A simple yet realistic model that explicitly incorporates both transaction costs and risk load is put forth in this paper It is shown that, under very general conditions, the optimal risk sharing arrangement which results is constructed in layers. Remarkably simple expressions are given for the optimal boundaries between layers as well as each participating insurers share of each layer: Several examples are included that illustrate the application of the model.