Uberrimae Fidei and Adverse Selection: the equitable legal judgment of Insurance Contracts

This paper examines uberrimae fidei (utmost good faith) with adverse selection in an insurance market. If consumers know their risk type (they know their expected loss), and if they understand the concept of uberrimae fidei, adverse selection is completely eliminated. However, if uberrimae fidei is strictly enforced by the courts, insurers have no incentive to do any underwriting whatsoever. Therefore, whether consumers know their risk type or not, and whether they understand uberrimae fidei, is of paramount importance. If consumers don’t know their risk type or don’t understand uberrimae fidei, then the (equitable) non-strict enforcement (judicial ruling) of contracts of insurance can be efficiency enhancing as it can create an ex-ante incentive for insurers to underwrite. With an ex-ante positive probability that a court may rule equitably in favor of the insured, the insurer engages in underwriting as part of its profit maximization objective, helping insureds to discover their risk type and/or educating potential insureds on the requirements of a contract of uberrimae fidei. This paper therefore contributes a new theory of underwriting.