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The Microeconomics of Insurance

Ray Rees and Achim Wambach

Abstract
In this relatively short survey, we present the core elements of the microeconomic analysis of insurance markets at a level suitable for senior undergraduate and graduate economics students. The aim of this analysis is to understand how insurance markets work, what their fundamental economic functions are, and how efficiently they may be expected to carry these out.

Contents

1 Introduction 1

2 The Demand for Insurance 9
2.1 Introduction 9
2.2 Two Models of the Demand for Insurance 12
2.3 Comparative Statics: The Properties of the Demand Functions 23
2.4 Multiple Loss States and Deductibles 27
2.5 Insurance Demand with State Dependent Utility 32
2.6 Insurance Demand and Uninsurable Risk 38
2.7 Conclusions 45

3 The Supply of Insurance 47
3.1 Introduction 47
3.2 Risk Pooling 49
3.3 Risk Spreading 53
3.4 Insurance Costs: The Raviv Model 56
3.5 Capital, Solvency, and Regulation 63

4 Adverse Selection 71
4.1 Introduction 71
4.2 Adverse Selection in Competitive Insurance Markets 72
4.3 Categorical Discrimination 94
4.4 Endogenous Information Acquisition 101
4.5 Dynamic Adverse Selection 107

5 Moral Hazard 121
5.1 Introduction 121
5.2 Single Period Contracts Under Moral Hazard 124
5.3 Dynamic Moral Hazard 140
5.4 Insurance Fraud 148

References