Adverse Selection in Insurance Contracting

Abstract

In this survey we present some of the more significant results in the literature on adverse selection in insurance markets. Sections 1 and 2 introduce the subject and Section 3 discusses the monopoly model developed by Stiglitz (1977) for the case of single-period contracts extended by many authors to the multi-period case. The introduction of multi-period contracts raises many issues that are discussed in detail; time horizon, discounting, commitment of the parties, contract renegotiation and accidents underreporting. Section 4 covers the literature on competitive contracts. The analysis is more complicated because insurance companies must take into account competitive pressures when they set incentive contracts. As pointed out by Rothschild and Stiglitz (1976), there is not necessarily a Cournot-Nash equilibrium in the presence of adverse selection. However, market equilibrium can be sustained when principals anticipate competitive reactions to their behavior or when they adopt strategies that differ from the pure Nash strategy. Multi-period contracting is discussed. We show that different predictions on the evolution of insurer profits over time can be obtained from different assumptions concerning the sharing of information between insurers about individual's choice of contracts and accident experience. The roles of commitment and renegotiation between the parties to the contract are important. Section 5 introduces models that consider moral hazard and adverse selection simultaneously and Section 6 covers adverse selection when people can choose their risk status. Section 7 discusses many extensions to the basic models such as risk categorization, multidimensional adverse selection, symmetric imperfect information, reversed or double-sided adverse selection, principals more informed than agents, uberrima fides and participating contracts.