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What is an Assurance Contract?

Article Details
  • Written By: C. Daw
  • Edited By: O. Wallace
  • Last Modified Date: 20 January 2019
  • Copyright Protected:
    2003-2019
    Conjecture Corporation
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An assurance contract is a financial agreement that ensures that all the people who utilize the service are under a commitment to pay for it, which eliminates the groups of people that either do not pay for the service, or they only pay a small amount while continuing to use it. These types of people are called free riders, and the assurance contract is set into place to prevent them from using the given company. When a large group of free riders use a service, the company begins to lose money and it comes to point in the operations of the business that they are no longer making a profit. This hurts the people that do pay for the service because it is either discontinued, or the rates increased in order to compensate. The contract, when in effect, does not allow this to happen because the free riders are required to pay or else the service is shut off for them, making the company profitable once again, which keeps the service available and affordable for everyone that uses it.

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Even though an assurance contract will not guarantee that all of the consumers will pay for the services that they receive, it does give the company the right to single them out and turn their service off. In this way the business may only lose money for one or two months, rather than having an ongoing problem that slowly drains their profits. A small amount, such as this, is also substantially easier to collect upon when compared to larger amounts. If the free rider decides that they need the service that is being offered, they will likely pay the amount owed, and then have it again after they pay a deposit fee which will be large enough to cover at a least a month of the service. In this way the company can shut it off again if the consumer does not pay, but will lose little if any money.

Specialists within the financial industry, such as Bagnoli and Linman in 1989, state that this particular problem is a game theoretic issue, which is why they began using an assurance contract. This simply means that in order for all people to gain from a particular service, even the company providing it, action must be taken to eliminate large amounts of free riders from taking advantage of the system. Basically, the way that this is done is by instead of raising the fees for the service, the price is lowered, which makes it affordable for everyone. In this way the amount of free riders dramatically decreases since the majority of them can afford to make the total payments after the fees are lowered, so they will continue to do so.

In this way more paying customers are gained, and there are fewer free riders. This is what the assurance contract aids with because it functions on the premise that people agree to pay a specific amount for a particular action as long as the expected level of contribution is achieved. When the contribution is met by a predetermined date, the service is made available to all the people who had contributed in the first place. If the expected contribution amount is not made by the expected date, all the parties that have made the payment would be refunded the amount that was given. If the contributed amount exceeds the target amount the group will distribute the amount by refunding it or by using it to improve the existing service.

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