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Uncertain Costs and Vertical Differentiation in an Insurance Duopoly

  • Radoslav S. Raykov
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    Classical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm’s ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers’ quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.

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    Paper provided by Bank of Canada in its series Working Papers with number 14-14.

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    Length: 41 pages
    Date of creation: 2014
    Date of revision:
    Handle: RePEc:bca:bocawp:14-14
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    2. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
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    15. Naoto Jinji & Tsuyoshi Toshimitsu, 2004. "Minimum Quality Standards under Asymmetric Duopoly with Endogenous Quality Ordering: A Note," Journal of Regulatory Economics, Springer, vol. 26(2), pages 189-199, 09.
    16. Julien Hardelin & Sabine Lemoyne de Forges, 2012. "Raising Capital in an Insurance Oligopoly Market," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 37(1), pages 83-108, March.
    17. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262200716, June.
    18. Maxwell, John W., 1998. "Minimum quality standards as a barrier to innovation," Economics Letters, Elsevier, vol. 58(3), pages 355-360, March.
    19. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June.
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