Ambiguity Aversion in Competitive Insurance Markets: Adverse and Advantageous Selection

We analyze an extension of the Rothschild-Stiglitz model with ambiguous loss probabilities and ambiguity-averse consumers to determine whether there are adverse or advantageous selection equilibria. We show that non-increasing absolute ambiguity aversion is sufficient for adverse selection. We show generally that actuarially fair pricing is also sufficient for adverse selection and that advantageous selection equilibria are inefficient. We then characterize the effect of ambiguity on the Rothschild-Stiglitz (RS) and Wilson-Miyazaki-Spence equilibrium under ambiguity aversion. In general, there is a deductible effect and an ambiguity effect both of which influence the critical proportion of high risks required for the RS equilibrium to exist and social welfare. We derive conditions under which ambiguity increases or decreases social welfare.