Severity Risk and the Adverse Selection of Frequency Risk
J. OF RISK AND INSURANCE, Vol. 62 No. 4, December 1995
Posted: 3 Jul 1998
This article shows how the introduction of severity risk into a simple model of insurance markets affects the optimal level of insurance. Also examined is how severity risk affects the equilibrium for an insurance market exhibiting adverse selection in the frequency risk. Individuals are assumed to possess identical loss severity distributions, but differ in their privately-known probabilities of having a loss. In particular, the effects of severity risk on the Nash equilibrium of Rothschild and Stiglitz (1976), on the anticipatory equilibrium of Wilson (1977), and on Miyazaki's (1977) extension of Wilson's equilibrium are analyzed. Severity risk is shown to affect the type of equilibrium contracts (pooling vs. separating), equilibrium levels of coverage, and overall societal welfare.
JEL Classification: G22
Suggested Citation: Suggested Citation