Insurance as a lemons market: Coverage denials and pooling

Research output: Contribution to journalArticlepeer-review

Abstract

The standard monopoly insurance model with adverse selection implies that there are always gains to trade, that only the best (unobservable) risks can go uninsured, and that a profit-maximizing menu cannot pool all types. We show that insurance-provision costs can explain both coverage denials only to those likely to be the worst risks and complete pooling. Specifically, we prove a general comparative statics theorem formalizing coverage denials only to those deemed to be the worst risks; and two theorems showing that the insurer offers a single contract (complete pooling), with either zero or positive coverage. We point out some implications of these results for empirical work on insurance. Our results expand upon a point made by Hendren (2013), that the main effect of adverse selection on insurance might not be misallocation in active markets – the traditional emphasis after Rothschild and Stiglitz (1976) – but simply in shutting down markets, as in Akerlof (1970) classic lemons model.

Original languageEnglish (US)
Article number105085
JournalJournal of Economic Theory
Volume189
DOIs
StatePublished - Sep 2020

Keywords

  • Adverse selection
  • Coverage denials
  • Insurance
  • Loading
  • Pooling

ASJC Scopus subject areas

  • Economics and Econometrics

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