Hidden insurance in a moral‐hazard economy

• DOI: http://doi.org/10.1111/1756-2171.12110
• Author: Winfried Koeniger,Giuseppe Bertola
• Published date: 01 October 2015
• Date: 01 October 2015

RAND Journal of Economics

Vol.46, No. 4, Winter 2015

pp. 777–790

Hidden insurance in a moral-hazard

economy

Giuseppe Bertola∗

and

Winfried Koeniger∗∗

We analyze the general equilibrium of an economy in which a competitive industry produces

nonexclusive insuranceservices. The equilibrium is inefficient because insurance contracts cannot

control moralhazard, and welfare can be improvedby policies that reduce insurance by increasing

its price above marginal cost. We discuss how insurance production costs that exceed expected

claim payments interact with moral hazard in determining the equilibrium’s inefficiency, and

show that these costs can make insurance premiaso actuarially unfair as to validate the standard

first-order conditions we exploit in our analysis.

1. Introduction

When a single exclusive insurer of a specific risk does not observe the insured’s behavior,

but knows how that behavior influences the probability of claims, partial insurance can improve

efficiency by givingthe insured incentives to exert loss-prevention efforts. If the insured may also

obtain coverage from other insurers, however,it can be difficult or impossible to ensure that losses

are only partially insured. For example, rental car contracts that do not include collision damage

insurance are supposed to encourage safe driving but do not give such incentivesif customers are

covered by secondary car insurance contracts.

Competition among nonexclusive insurers implies that coverage is excessive in equilibrium

(Pauly, 1974; similar inefficiencies can arise in credit markets where default probabilities depend

on the total amount of credit issued by competing lenders, as in, e.g., Bizer and DeMarzo,

1992). Insurers can address this problem by sharing information about each individual’s coverage,

requiring the presentation of original receipts to prevent the submission of claims to other insurers,

or refusing to pay claims for risks covered by multiple policies. It can be difficult to discover

hidden insurance, however, and the resulting moral-hazard inefficiencies may be particularly

∗Edhec Business School and CEPR, CESifo, CFS; giuseppe.bertola@edhec.edu.

∗∗University of St. Gallen and CEPR, CFS, IZA; winfried.koeniger@unisg.ch.

Part of this research was conducted by Bertola at the Universit`

a di Torino and by Koeniger at Queen Mary, University

of London. A previous version of this article was circulated as CEPR Discussion Paper no. 9864. This version benefits

from helpful comments by the Editor and the referees, as well as bycolleagues and seminar par ticipants. Wethank Adam

Pigon and Anil Shamdasani for careful proofreading.

C2015, The RAND Corporation. 777