Financial Economics I Lecture Notes on : Competitive Markets for Insurance

Do competitive insurance markets function orderly in the presence of moral hazard and adverse selection? What are the properties of allocations attainable as competitive equilibria of such economies? And in particular, are competitive equilibria incentive efficient? The fundamental contribution on competitive markets for insurance contracts is Prescott and Townsend (1984). They analyze Walrasian equilibria of economies with moral hazard and with adverse selection when exclusive contracts are enforceable. While for moral hazard economies they prove existence and constrained versions of the first and second theorems of welfare economics,their method does not succeed in the case of adverse selection economies. They conclude (p. 44) that “there do seem to be fundamental problems for the operation of competitive markets for economies or situations which suffer from adverse selection.” ∗Elaborated from un-published notes written with Piero Gottardi, Univ. of Venice 1The standard strategic analysis of competition in insurance economies, due to RothschildStiglitz (1976), considers the Nash equilibria of a game in which insurance companies simultaneously choose the contracts they issue, and the competitive aspect of the market is captured by allowing the free entry of insurance companies. Such equilibrium concept does not perform too well: equilibria in pure strategies do not exist for robust examples (Rothschild-Stiglitz (1976)), while equilibria in mixed strategies exist (Dasgupta-Maskin (1986)) but, in this setup, are of difficult interpretation. Even when equilibria in pure strategies do exist, it is not clear that the way the game is modelled is appropriate for such markets, since it does not