Separating Contract Flashcards
What are Separating Contracts?
Pair of Contract that cause 2 Types of Customers to Separate / Self-select by choosing between Contracts
What do the 2 Separating Contracts offer?
- Full Insurance at Fair Odds Premium / £ of Compensation of p’ for H.R - e.g. Point K
- Partial Insurance at Lower Fair Odds Premium / £ of Compensation for L.R - e.g. Point R
Why can K and R Separate Individuals?
R lies on Intersection of FF’ (L.R F.O line) & EU’ (H.R I.C)
- Through K –> H.R Indifferent between K and R - same utility level
– Assume Epsilon Altruism - H.R choose K –> Break Even
Induce Seperating Choices + Insurer Breaks Even
What determines whether Separating Contracts is a NE?
Position of Market Average Fair Odds Line relative to I.C for L.R given the S.C
When is K and R a NE?
MM’ lies everywhere BELOW L.R I.C through R (EU2)
- Any Contract that can attract L.R away, also attracts H.R away as well + lies Above MM’ –> Exp. Losses
K and R is a NE
When is K and R NOT a NE?
MM’ cuts through L.R I.C through R (EU2)
- Any Contract in V - still below MM’ –> Supernormal Profits
– H.R still takes the contract –> V not N.E
=> K and R not NE - too many L.R types –> Pooling Contract
What is a Reactive Equilibrium?
Insurance Company will only introduce New Contract if it believes it will remain profitable once others have Reacted w/ new Introductions
When is there a Reactive Eq.?
Reactive Eq. = Separating Eq. (When No NE)
Is V a Reactive Eq.?
V becomes Unprofitable - due to Competition –> Moves towards MM’
– So should NOT Introduce V
What Inefficiencies are Caused by Asymmetric Info in Selection Problem?
- Non-Existence - NE may not exist at all
- Separating Eq. can be Inefficient - L.R Suffer Utility Loss to distinguish themselves (must choose Partial
- ‘Better’ Risks suffer - Negative Externality
