Advantageous Selection in Insurance Markets with Compound Risk

Rachel J. Huang, Arthur Snow, Larry Y. Tzeng

Research output: Contribution to journalArticlepeer-review

1 Scopus citations

Abstract

Building on the model of insurance contracting with hidden knowledge of risk class introduced by Rothschild and Stiglitz (1976), we assume that insurance applicants fail to reduce compound lotteries. In contrast with the adverse selection equilibrium identified by Rothschild and Stiglitz, in which coverage and expected claims frequency are positively correlated, we show that an advantageous selection equilibrium is possible, with coverage and expected claims frequency being negatively correlated. Whereas previous theories explain advantageous selection by adding a hidden action or a second dimension of hidden knowledge, our analysis shows that advantageous selection can arise solely as a consequence of insurance applicants' attitude toward bearing compound risks.

Original languageEnglish
Pages (from-to)171-192
Number of pages22
JournalGENEVA Risk and Insurance Review
Volume42
Issue number2
DOIs
StatePublished - 1 Sep 2017

Keywords

  • Advantageous selection
  • Adverse selection
  • Increasing aversion to second-stage risk

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