DP15234 Organizing insurance supply for new and undiversifiable risks

Author(s): David Alary, Catherine Bobtcheff, Carole Haritchabalet
Publication Date: August 2020
Date Revised: September 2020
Keyword(s): Coinsurance, common value divisible goods auctions, Competition, reserve price, undiversifiable and new risks
JEL(s): D44, D82, G22
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15234

This paper explores how insurance companies can coordinate to extend their joint capacity for the coverage of new and undiversifiable risks. The undiversifiable nature of such risks causes a shortage of insurance capacity and their limited knowledge makes learning and information sharing necessary. We develop a unified theoretical model to analyse co-insurance agreements. We show that organizing this insurance supply amounts to sharing a common value divisible good between capacity constrained and privately informed insurers with a reserve price. Coinsurance via the creation of an insurance pool turns out to operate as a uniform price auction with an ``exit/re-entry'' option. We compare it to a discriminatory auction for which no specific agreements are needed. Both auction formats lead to different coverage/premium tradeoffs. If at least one insurer provides an optimistic expertise about the risk, the pool offers higher coverage. This result is reversed when all insurers are pessimistic about the risk. Static comparative results with respect to the severity of the capacity constraints and the reserve price are provided. In the case of completely new risks, a regulator aiming at maximizing the expected coverage should promote the pool when the reserve price is low enough or when competition is high enough.