E¢ ciency of Competition in Insurance Markets with Adverse Selection

There is a general presumption that competition is a good thing. In this paper we show that competition in the insurance markets can be bad when there is adverse selection. Using the dual theory of choice under risk, we are able to fully characterize both the competitive and the monopoly market outcomes. When there are two types of risk, the monopoly dominates competition if and only if competition leads to market unravelling. When there are a continuum of types the e¢ ciency of competition is less trivial. In e¤ect monopoly is shown to provide better insurance but at the cost of driving out some agents from the market. Performing simulation for di¤erent distributions of risk, we …nd that monopoly in general performs (much) better than competition in terms of the realization of the gains from trade across all traders in equilibrium. The reason is that the monopolist can exploit its market power to relax the incentive constraints. Keywords: monopoly, competition, non-expected utility, insurance, adverse selection. JEL classi…cation: G22, G82 We are grateful to Enrico Minelli, Francesca Stro¤olini, Piero Tedeschi and Izabela Jelovac for helpful comments and suggestions. This work also bene…tted from comments and feedback from seminar audiences at CORE and the Universities of Liege and Milano Bocconi.