Comonotonicity and Pareto optimality, with application to collaborative insurance

Abstract

Two by-now folkloric results in the theory of risk sharing are that (i) any feasible allocation is convex-order-dominated by a comonotonic allocation; and (ii) an allocation is Pareto optimal for the convex order if and only if it is comonotonic. Here, comonotonicity corresponds to the so-called no-sabotage condition, which aligns the interests of all parties involved. Several proofs of these two results have been provided in the literature, all based on a version of the comonotonic improvement algorithm of Landsberger and Meilijson (1994) and a limit argument based on the Martingale Convergence Theorem. However, no proof of (i) is explicit enough to allow for an easy algorithmic implementation in practice; and no proof of (ii) provides a closed-form characterization of Pareto optima. In addition, while all of the existing proofs of (i) are provided only for the case of a two-agent economy with the observation that they can be easily extended beyond two agents, such an extension is far from being trivial in the context of the algorithm of Landsberger and Meilijson (1994) and it has never been explicitly implemented. In this paper, we provide novel proofs of these foundational results. Our proof of (i) is based on the theory of majorization and an extension of a result of Lorentz and Shimogaki (1968), which allows us to provide an explicit algorithmic construction that can be easily implemented beyond the case of two agents. In addition, our proof of (ii) leads to a crisp closed-form characterization of Pareto-optimal allocations in terms of α-quantiles (mixed quantiles). An application to peer-to-peer insurance, or collaborative insurance, illustrates the relevance of these results.