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Endogenous Categorization in Insurance

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  • MATTIAS K. POLBORN

Abstract

This paper analyzes the welfare properties of equilibrium when insurers use observable actions to classify consumers into different risk categories, and consumers' choice is influenced by the insurance market consequences of their actions. Specifically, we analyze this problem at the example of a car insurance market, in which individual preferences over car types are correlated with risk type and used by insurance firms for ratemaking. Equilibrium premiums for each car are determined by the losses that it generates. Consumers take insurance premiums into account when deciding which car to buy. This creates an incentive to buy the car that is preferred by more low risk individuals. From a utilitarian point of view, this incentive is excessive. Depending on parameters, it may even be possible to construct a tax-subsidy scheme with balanced budget that Pareto improves on the market equilibrium. Copyright © 2008 Wiley Periodicals, Inc..

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  • Mattias K. Polborn, 2008. "Endogenous Categorization in Insurance," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 10(6), pages 1095-1113, December.
  • Handle: RePEc:bla:jpbect:v:10:y:2008:i:6:p:1095-1113
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    References listed on IDEAS

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    1. Chiappori, Pierre-Andre & Salanie, Bernard, 1997. "Empirical contract theory: The case of insurance data," European Economic Review, Elsevier, vol. 41(3-5), pages 943-950, April.
    2. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, May.
    3. Michael Rothschild & Joseph Stiglitz, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, Oxford University Press, vol. 90(4), pages 629-649.
    4. Crocker, Keith J & Snow, Arthur, 1986. "The Efficiency Effects of Categorical Discrimination in the Insurance Industry," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 321-344, April.
    5. Michael Hoy, 1982. "Categorizing Risks in the Insurance Industry," The Quarterly Journal of Economics, Oxford University Press, vol. 97(2), pages 321-336.
    6. Polborn, Mattias K., 1998. "Mandatory insurance and the judgment-proof problem," International Review of Law and Economics, Elsevier, vol. 18(2), pages 141-146, June.
    7. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
    8. Shavell, S., 1986. "The judgment proof problem," International Review of Law and Economics, Elsevier, vol. 6(1), pages 45-58, June.
    9. Bond, Eric W & Crocker, Keith J, 1991. "Smoking, Skydiving, and Knitting: The Endogenous Categorization of Risks in Insurance Markets with Asymmetric Information," Journal of Political Economy, University of Chicago Press, vol. 99(1), pages 177-200, February.
    10. Michael Spence, 1973. "Job Market Signaling," The Quarterly Journal of Economics, Oxford University Press, vol. 87(3), pages 355-374.
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    Cited by:

    1. Georges Dionne & Casey Rothschild, 2014. "Economic Effects of Risk Classification Bans," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 39(2), pages 184-221, September.

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