Ambiguity Aversion in Competitive Insurance Markets with Asymmetric Information
44 Pages Posted: 5 Apr 2019
Date Written: March 10, 2019
We analyze the effect of ambiguous loss probabilities on competitive insurance markets with asymmetric information. We characterize equilibria under actuarially fair pricing with preferences that are second-order ambiguity averse (have smooth indifference curves). We also show existence of uniqueness of the second-best contracts and provide a characterization. Non-increasing absolute ambiguity aversion is sufficient for adverse selection in the smooth model. We then determine the effect of ambiguity on equilibrium under ambiguity aversion. There is a coverage effect because ambiguity relaxes the self-selection constraint and raises the available coverage for the low risks, and an ambiguity effect because ambiguity makes ambiguity averse agents worse off. Both effects are conflicting when it comes to their impact on the critical pro-portion of high risks required for a Rothschild-Stiglitz equilibrium to exist and social welfare. We derive conditions that allow to resolve the indeterminate social welfare effect.
Keywords: adverse selection, ambiguity, efficiency, second best, uncertainty averse preferences, welfare
JEL Classification: D80, G22, C30
Suggested Citation: Suggested Citation