The Legal Constraint of Misrepresentation in Insurance Market and its Impact on Insurance Contracts
33 Pages Posted: 19 Aug 2015
Date Written: July 1, 2015
We advance the literature starting from the work by Dixit (2000), who considers the effect of the principle of good faith on adverse selection. Introducing a post-loss risk misrepresentation testing in a competitive insurance market model, we identify a sufficient condition to guarantee that a market equilibrium exists which is unique and characterized by a set of separating full coverage contracts if the test for misrepresentation is sufficiently accurate. We further investigate the case that the full-coverage equilibrium is not attained. Specifically, we show: (1) how the easiness of the post-loss test would impact the insurance contract, and (2) that the market equilibrium approximates the first-best under feasible conditions, which tend to be satisfied by the intrinsic nature of insurance contracts. Lastly, we describe the insurance contract after the introduction of a post-loss test given the use of underwriting, and show that the post-loss test completely takes the place of underwriting when either or both of the tests can be chosen.
Keywords: misrepresentation, good faith, adverse selection, insurance
JEL Classification: D81, D82, G22
Suggested Citation: Suggested Citation