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Adverse Selection with the Boot on the Other Foot: Insurer Insolvency as a Problem in Asymmetric Information

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Abstract

The problem of insurer insolvency has almost exclusively been seen as an issue in regulation. However, it is also clear that there is an obvious element of asymmetric information present when insolvency is possible. Insurers are clearly better informed of their probability of defaulting on an insurance arrangement than are their insureds, and just as clearly, that probability affects the value of the contract to the insured. With that in mind, we recast the issue of insurer insolvency within the context of asymmetric information, specifically, adverse selection. In our model, the (risk-neutral) insurer is the informed agent, and the (risk-averse) policyholder is the uninformed principal. Thereby, the classic player identities in an asymmetric information problem are reversed. We find equilibrium contract menus for the cases of perfect competition between insurers, and for the case of a single monopolistic insurer.

Suggested Citation

  • Yuechen Dai & Richard Watt, 2023. "Adverse Selection with the Boot on the Other Foot: Insurer Insolvency as a Problem in Asymmetric Information," Working Papers in Economics 23/02, University of Canterbury, Department of Economics and Finance.
    • Handle: RePEc:cbt:econwp:23/02
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    File URL: https://repec.canterbury.ac.nz/cbt/econwp/2302.pdf
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    References listed on IDEAS

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    1. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
    2. Neil A. Doherty & Harris Schlesinger, 1990. "Rational Insurance Purchasing: Consideration of Contract Nonperformance," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 105(1), pages 243-253.
    3. Michael Rothschild & Joseph Stiglitz, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 90(4), pages 629-649.
    4. Olivier Mahul & Brian Davern Wright, 2004. "Implications of incomplete performance for optimal insurance," Post-Print hal-01952109, HAL.
    5. repec:bla:econom:v:71:y:2004:i:284:p:661-670 is not listed on IDEAS
    6. Wanda Mimra & Achim Wambach, 2019. "Endogenous Insolvency in the Rothschild–Stiglitz Model," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 86(1), pages 165-181, March.
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    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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