BUSE3003A – Block 1

PAPER 4

Rothschild, M., & Stiglitz, J. E. (1976).

Equilibrium in Competitive Insurance
Markets

Agata.macgregor@wits.ac.za

1
INTRODUCTION
• Paper analyses competitive markets in which characteristics of the
commodities exchanged are not fully known to at least one of the parties to
the transaction = imperfect information.

• Imperfect information – insurance companies cannot tell what type of risk

individual is = problem.
• This paper gives a ‘solution’ to this problem.

• This paper shows that not only may competitive equilibrium not exist, but
should equilibria exist, they may have strange properties.

• Create a model – starts off simple, with some assumptions. Then start with
the perfect world (perfect competition), then only add information
asymmetry into the model.

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INSURANCE MARKETS
• There is a particular amount of insurance that an individual can buy at a
certain price.
• If individuals reveal all information (tell the insurer your risk and the insurer
believes you) = everybody could be better off – everything would be perfect.
• Just by being high-risk, high-risk individuals cause an externality because
they make low-risk individuals worse off [low-risk individuals are forced to
pay a higher premium].
• Low risk individuals are now worse off than they would be in the absence of
the high-risk individuals.
• In other words: high risks (lemons) cause harm to low risk people
because high risk cause low risk to pay more & force them to leave the
market.
• The absence of low-risk individuals does little to improve the well-being of
high-risk individuals.
• Lemons will be left and charged a premium as a lemon. If we take low
risks away, the lemon will still have to pay a lemon premium.
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INSURANCE MARKETS

In summary: we have high-risk people and low-risk people.

• If we remove high risk – then the low-risk people are better off –
they would be charged much less.

• If we remove low risk – this has a really small impact on the high-risk
people – they will still be charged a high amount because they are
high risk.

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THE BASIC MODEL
Motor vehicle situation

• Four assumptions are made:

• No accident occurs = Individual has income = Wealth (W)
• Accident occurs =Individual has income W – d (loss)
• Can insurer against this accident/loss (d) = pay a premium of α1
• If you do have an accident and you bought insurance – you will be paid a
claim amount of 2

• There are therefore two possibilities:

• No accident occurs (W1)
• Accident occurs/takes place (W2)

• There are also two scenarios:

• No insurance 5
• Insurance
THE BASIC MODEL

When looking at an insurance market there are only two participants –

people who demand insurance and companies who supply that
insurance. Therefore, we have to look at both demand and supply of
insurance to understand how the market works.

DEMAND – Look at individuals and the people who demand insurance

contracts
• In an insurance market, insurance contracts (α) are traded.
• An individual purchases an insurance contract so as to alter his
pattern of income across states of nature.

• People buy insurance because they are risk averse & they want to
maximize their expected utility.
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THE BASIC MODEL

• According to expected utility theorem – given certain assumptions

concerning preferences - people have the following expected utility function
which is a function of 3 things:
Expected Utility function

• (1)

p = probability If no accident If accident

of an accident
occurring

Value of an insurance contract based on

α tells uswe are dealing with acase where the individual haschosen ¿buy insurance

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THE BASIC MODEL

• From all the insurance contracts the individual is offered he chooses the one
contract to maximize V(p,α).

• The individual also has the option of not buying insurance:

The insurance contract has been replaced by zero

• Therefore:

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THE BASIC MODEL

SUPPLY – companies selling insurance

• How do insurance companies decide which contracts to sell and to which

people?

• The insurance company must decide to sell insurance & must decide at what
price. The certainty for the insurance company is the premium payments –
they come in every month or every year. If you do not pay your premium –
no cover.

• There is uncertainty for the insurance company as to when they will have to
pay out. It is uncertain as to what claim payouts the insurer will have to
make – therefore there is an aspect of uncertainty w.r.t. their profits. The
return that the insurance company will get on an insurance contract is a
random variable.
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 THE BASIC MODEL
• Assume: Insurance companies are risk neutral – they are only concerned
with maximizing expected profits – therefore they will have a different utility
function to that of the demand individuals

• The purpose for an insurance company is to maximize expected profits.

• Assume: Any contract sold is expected to make an expected profit – but it

may not.

• Therefore, contracts sold to the individual are worth (to the insurer):

= profits = probability of insured suffering a loss i.e. probability of an accident occurring

• (2)

= insurance If no accident – If accident – Insurer will 10

contact – can Insurer will only receive premium AND
this ever be get premium. will make claim payment
zero? No claim pay-
out
THE BASIC MODEL

Some assumptions:

• Free entry into the market

• Any contract that is demanded, as long as it makes expected profits, will be

supplied

• Information about ACCIDENT PROBABILITIES = key assumption

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THE BASIC MODEL

DEFINITION OF EQUILBRIUM

• The Cournot-Nash equilibrium first.

• R+S assume: an individual can only buy one insurance contract which means
that the seller of insurance specifies both the price and the quantity.

• Equilibrium in a competitive insurance market is a set of contracts such that

when customers choose to maximize their expected utility the following two
conditions hold:

1. No contract in equilibrium, if offered, can make negative expected

profits

2. No contract outside of equilibrium, whereby if offered, makes a

nonnegative profit. 12
1. EQUILIBRIUM WITH IDENTICAL
CUSTOMERS

• Identical customers tell us that every individual has the same p – the same
probability of an accident occurring.

• Looking at a perfect world.

• The insurer knows the individuals p-value = all they have to do is look at past
claims history.

• Therefore, we have perfect information in this example.

• Refer to graphs.

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1. EQUILIBRIUM WITH IDENTICAL
CUSTOMERS

In summary:

Step 1 – look at axis x and y

Step 2 – 45-degree line

Step 3 – fair odds line EF

Step 4 – Indifference Curve(s) (IC)

Step 5 – Check equilibrium conditions

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2. EQUILIBRIUM WITH TWO NON-
IDENTICAL (DIFFERENT) CUSTOMERS,
IMPERFECT INFO AND ONE CONTRACT
Now we have two different kinds of people:
• High risk people = lemons
• Low risk people = good risks

Therefore, we will have two IC’s

Also, because we have two different individuals – each individual will have a
different p. The probability of an accident occurring:
• High risk = pH
• Low risk = pL

The market can have only two types of equilibria: pooling equilibria (where
both high and low buy the same contract) and separating equilibria (high buy a 15
separate contract to low). Which one will this Case show?
2. EQUILIBRIUM WITH TWO NON-
IDENTICAL CUSTOMERS
• Insurer offers one type of contract for both groups of people because the
insurer cannot tell who is a high risk and who is a low risk = imperfect
information. – so, we start with a pooling equilibrium.

• Assume: the insurance company has λ amount of high-risk people in the

market and 1 – λ of low-risk people.

• But the insurer still does not know which group the customer falls into.

• Therefore, the insurer can work out an average probability:

•

• Refer to graphs.
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2. EQUILIBRIUM WITH TWO NON-
IDENTICAL CUSTOMERS

In summary:

Step 1 – look at axis x and y

Step 2 – 45-degree line

Step 3 – fair odds line EF

Step 4 – IC

Step 5 – Check equilibrium conditions

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3. EQUILIBRIUM WITH TWO DIFFERENT
CUSTOMERS, IMPERFECT INFO AND TWO
DIFFERENT CONTRACTS

Now an insurance company will offer two different contracts:

• One for low risks – the insurer needs to find a way to make sure that only
the low risks like this contract
• One for high risks - the insurer needs to find a way to make sure that
only the high risks like this contract

• By choosing a contract the individual reveals what type of risk they are to
the insurer i.e., they reveal their inherent risk status.

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3. EQUILIBRIUM WITH TWO DIFFERENT
CUSTOMERS, IMPERFECT INFO AND TWO
DIFFERENT CONTRACTS

Now that we are offering two contracts, we must have two fair-odds lines

Problem: At the beginning as the insurer is about to offer both contracts – the
insurer does not know and cannot tell who is high risk and who is low risk (=
information asymmetry) – therefore will have to show both contracts to the
individual and only then will that individual be able to reveal him/herself. But
by then it is too late…both contracts have been shown to the prospective
insured.

Therefore, the insurer still has not separated high and low risk! Therefore, a
new solution is needed.

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3. EQUILIBRIUM WITH TWO DIFFERENT
CUSTOMERS, IMPERFECT INFO AND TWO
DIFFERENT CONTRACTS

Insurer needs to offer a contract sold to low risk individuals that will not attract
any high-risk individuals.

In this way the insured does not have to tell the insurer what type of risk they
are – because the low risk will buy and the high risk will buy .

If the insurer could tell who is high and who is low, they would happily offer to
the low risks and to the high risks. But because of information asymmetry the
insurer does not know and needs to offer an alternative.

Check equilibrium conditions - This establishes that a competitive insurance

market may have no equilibrium.
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ROBUSTNESS – THREE MAIN CONCLUSIONS
FROM THE ABOVE ANALYSIS

• Competition in markets that have imperfect information are more complex

than standard models.

• Equilibrium may not exist.

• Competitive equilibria are not Pareto optimal - The separating equilibrium

may not be Pareto optimal – but there may exist a pair of policies that break
even together that make both groups better off.

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CASE 6: ALTERNATIVE EQUILIBRIUM
CONCEPTS – WILSON EQUILIBRIUM

• There are a number of other concepts of equilibrium – these differ with

respect to their assumptions concerning the behavior of the insurance
company in the market.

• In their first model [Cournot-Nash equilibrium] the insurance company

assumes that its actions do not affect the market i.e. the set of policies offered
by other firms is independent of its own offering.

• Now we change from a Cournot-Nash equilibrium to a Wilson equilibrium

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WILSON EQUILIBRIUM

A Wilson equilibrium is a set of contracts such that customers choose among

them as to maximize expected utility and has two conditions:

1. All contracts made nonnegative profits [the same as before]

2. There is no new contract, if offered, which will make positive profits even
when all contracts that lose money as a result of this entry are withdrawn
i.e. if a contract is offered and it starts to make a loss, it is thrown out of
the market never to return again.

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WILSON EQUILIBRIUM

Step 1:
• We have the same as diagram 3 – An equilibrium set of (, ) insurance
contracts.
• Average fair-odds line is given by EF

Step 2: Now we test to see if our new equilibrium conditions hold

Step 4:
Now another insurance company comes along, and a different contract is
offered = .

Step 5: A cautionary note

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CONCLUSION
• The single price equilibrium of conventional competitive equilibrium (where
the supply side only determines price and not quantity) was shown to be no
longer viable.

• Market equilibrium, when it existed, consisted of contracts which specified

both prices and quantities.

• The high-risk individuals exert a negative (dissipative) externality on the low-

risk individuals.

• The structure of the equilibrium as well as its existence depended on a

number of assumptions that, with perfect information, were
inconsequential.

• Under quite plausible conditions (Cournot-Nash) equilibrium may not exist.

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• However, accepting Wilson’s equilibrium, it is evident that equilibrium does
exist and hence the insurance market will not fail.