Insurance Contracting with the Coexistence of Adverse Selection and Moral Hazard

40 Pages Posted: 27 Mar 2011 Last revised: 1 Apr 2014

See all articles by Zhiqiang Yan

Zhiqiang Yan

Western Illinois University - Department of Marketing and Finance

Hua Chen

University of Hawaiʻi at Mānoa

Date Written: May 10, 212

Abstract

The asymmetric information problem has been widely discussed in the context of insurance markets. Most of previous research usually treats adverse selection and moral hazard separately, though it is quite possible that they may coexist and interact with each other. In this paper, we build a principal-agent model to examine optimal contracts in a competitive insurance market facing adverse selection and moral hazard simultaneously. We apply the change-of-variable method and the Kuhn-Tucker conditions to solve the optimization programs and find that there are several forms of separating Nash equilibria, although separating Nash equilibria may not exist. Our model brings richer equilibria and retains some properties in the benchmark models of pure adverse selection and pure moral hazard. For example, no agent is offered full insurance, and the positive correlation between insurance coverage and risk type still holds. Our study on comparative statics indicates that, under some conditions, the optimal indemnity and premium, in general, decrease with the disutility, increase with the potential loss and decrease with the intial wealth of the insured.

Keywords: Insurance Contract, Adverse Selection, Moral Hazard

Suggested Citation

Yan, Zhiqiang and Chen, Hua, Insurance Contracting with the Coexistence of Adverse Selection and Moral Hazard (May 10, 212). Available at SSRN: https://ssrn.com/abstract=1792970 or http://dx.doi.org/10.2139/ssrn.1792970

Zhiqiang Yan (Contact Author)

Western Illinois University - Department of Marketing and Finance ( email )

Macomb, IL 61455
United States

Hua Chen

University of Hawaiʻi at Mānoa ( email )

2404 Maile Way, E-602e
Honolulu, HI 96822
United States
(808) 956-8063 (Phone)
(808) 956-9887 (Fax)

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