Adverse selection and equilibrium in liability insurance markets

Abstract

Models of asymmetric information in insurance markets typically consider insurance buyers with Bernoulli loss distributions differing in expected loss. This article analyzes markets where buyer loss distributions are characterized by mean-preserving spreads and insurers can classify applicants in terms of expected values but not by risk. Because liability losses are characterized by skewed continuous probability distributions, both discrete and continuous loss distributions are considered. In contrast to the single separating equilibrium in the classic Rothschild-Stiglitz insurance market, multiple separating equilibria are identified in this article: three in the discrete case and four in the continuous case. The possibility of extreme discontinuities in insurer policy offers provides a new explanation for crises in liability insurance markets.