De Feo, G. and Hindriks, J. (2005) Efficiency of competition in insurance markets with adverse selection. Discussion paper. Département des Sciences Économiques de l'Université catholique de Louvain Institut de Recherches Économiques et Sociales, Louvain-la-Neuve, Belgium.
There is a general presumption that competition is a good thing. In this paper we show that competition in the insurance markets can be bad when there is adverse selection. Using the dual theory of choice under risk, we are able to fully characterize both the competitive and the monopoly market outcomes. When there are two types of risk, the monopoly dominates competition if and only if competition leads to market unravelling. When there are a continuum of types the efficiency of competition is less trivial. In effect monopoly is shown to provide better insurance but at the cost of driving out some agents from the market. Performing simulation for different distributions of risk, we find that monopoly in general performs (much) better than competition in terms of the realization of the gains from trade across all traders in equilibrium. The reason is that the monopolist can exploit its market power to relax the incentive constraints.
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