Misinformation and Equilibrium in Insurance Markets

Kleindorfer, P. & Kunreuther, H.C. (1981). Misinformation and Equilibrium in Insurance Markets. IIASA Collaborative Paper. IIASA, Laxenburg, Austria: CP-81-030

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Abstract

This paper focuses on the role of misinformation by firms and consumers with respect to the selling and buying of insurance. For example, the reader may wish to think of automobile insurance when the firms do not know the accident probabilities for each of their customers and insured individuals in turn, may misperceive the probabilities of being involved in an accident.

Our point of departure is the model developed by Rothschild-Stiglitz which demonstrated that firms could distinguish between different types of risks by offering a set of policies consisting of a premium per dollar and a stated amount of coverage. We will investigate two types of equilibrium concepts in the spirit of this model: a traditional Nash equilibrium where each firm determines the set of policies it will offer under the assumption that all other firms make no changes in their offerings and a Wilson equilibrium here firms look far enough ahead in the future to evaluate the consequences of a new policy offering on the profitability of current policies.

The paper contrasts the Nash and Wilson equilibria for cases where consumers correctly perceive the probability of a loss as well as when they misperceive this probability. We focus attention on the case where there are two risk groups in order to highlight significant differences between Nash and Wilson equilibria through graphical procedures. The final portion of the paper generalizes the results to n risk groups and discusses the welfare implications of consumer misperceptions.

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