Participating insurance contracts and the Rothschild-Stiglitz equilibrium puzzle
AbstractWe show that an equilibrium always exists in the Rothschild-Stiglitz insurance market model with adverse selection when insurers can offer either non- participating or participating policies, i.e. insurance contracts which may involve policy dividends or supplementary calls for premium. The equilibrium coincides with the Miyazaki- Spence-Wilson equilibrium, which may involves cross-subsidization between contracts within subgroups of individuals. The paper establishes that participating policies act as an implicit threat that dissuades deviant insurers who aim at attracting low risk individuals only. The model predicts that the mutual corporate form should be prevalent in insurance markets or submarkets where second-best Pareto efficiency requires cross-subsidization between risk types. Stock insurers and mutuals may coexist, with stock insurers offering insurance coverage at actuarial price and mutuals cross-subsidizing risks.
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