Insurance Market with Self-Protection Activities and Risk Interdependencies: Profits, Market Structure, and Risk Exposure

Common economic models of insurance theory assume that insurers play no role in modifying the loss potential. Individual loss prevention decisions tend to reduce risk and even often affect risk faced by others. Incorporating these important features into an insurance market, we argue that insurers may alter the loss potential via their pricing strategy. This is because the (market equilibrium) price of insurance affects the individuals' prevention decisions. Individuals weigh the cost associated with prevention against the price of insurance coverage. In particular, when the insurance market is monopolistic, the insurer will take advantage of this effect and determine loss propensities in a sense optimal for him. This is because different loss propensities affect the individuals' willingness to pay for insurance and thus the potential extent of expected profit per policy. Premiums are then optimally chosen to reflect the trade-off between the number of purchasers and expected profit per policy. Such a strategic behavior of insurers may be a reason why they tend to invest in understanding the loss process: Insurers may indeed have an interest in understanding and eventually affecting underlying loss propensities in order to increase expected profits. Consistent with empirical evidence, we show that consumers are exposed to higher overall risk in a competitive insurance market compared with a monopolistic market.