Imperfect Tests and Natural Insurance Monopolies

Abstract

We consider a housing insurance market in which buildings have different damage probabilities. Insurers use imperfect tests to find out about the buildings' damage types. The insurance market is a natural monopoly. If more than one insurer is active, high risk house owners continue to apply to insurers until they are eventually assigned to a low risk class. First we show that the natural insurance monopoly need not be sustainable. Then we show that in the equilibrium industry structure the incumbent may accomodate entry even when the natural monopoly is sustainable. Our theoretical findings are thus able to explain recent observations from Germany and Switzerland where housing insurance damage rates and prices went up drastically after the transition from state monopolies to competitive environments.

JEL Classification: G22, L12, L85