Designing Optimal Disability Insurance: A Case for Asset Testing

Abstract

We analyze an implementation of an optimal disability insurance system as a competitive equilibrium with taxes. An optimum is implemented by an asset‐tested disability system in which a disability transfer is paid only if an agent has assets below a specified maximum. The logic behind this result is that an agent who plans to falsely claim disability ( a ) finds doing so unattractive if he does not adjust his savings and ( b ) cannot collect disability insurance if he does adjust his savings in the desired direction (upward). For a calibrated economy, we find that welfare gains from asset testing are significant.