DP16310 Risk Classification in Insurance Markets with Risk and Preference Heterogeneity

Author(s): Vitor Farinha Luz, Piero Gottardi, Humberto Moreira
Publication Date: June 2021
Keyword(s): Insurance Markets, Multidimensional private information, Risk Classification, Risk distribution
JEL(s): D82, G22, I13, I18
Programme Areas: Public Economics, Financial Economics, Organizational Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16310

This paper studies a competitive model of insurance markets in which consumers are privately informed about their risk and risk preferences. We provide a tractable characterization of equilibria, which depend non-trivially on consumers' type distribution, a desirable feature for policy analysis. The use of consumer characteristics for risk classification is modeled as the disclosure of a public informative signal. A novel monotonicity property of signals is shown to be necessary and sufficient for their release to be welfare improving for almost all consumer types. We also study the effect of changes to the risk distribution in the population as the result of demographic changes or policy interventions. When considering the monotone likelihood ratio ordering of distributions, an increase in the risk distribution leads to lower utility for almost all consumer types. In contrast, the effect is ambiguous when considering the first order stochastic dominance ordering.