Harmful competition in the insurance markets

Abstract

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 and that adverse selection is in general worse under competition than under monopoly. The reason is that monopoly can exploit its market power to relax incentive constraints by cross-subsidization between di erent risk types. Cream-skimming behavior, on the contrary, prevents competitive rms from using implicit transfers. In e ect monopoly is shown to provide better coverage to those buying insurance but at the cost of limiting participation to insurance. Performing simulation for di erent distributions of risk, we nd that monopoly in general performs (much) better than competition in terms of the realization of the gains from trade across all traders in equilibrium. However, most of the surplus is retained by the rm and, as a result, most individuals prefer competitive markets notwithstanding their performance is generally poorer than monopoly.