Smoking, Skydiving, and Knitting: The Endogenous Categorization of Risks in Insurance Markets with Asymmetric Information

We analyze the efficiency and market equilibirum effects of endogenous categorization, where insurance companies classify risks on the basis of insureds' voluntary consumption of products that are correlated with underlying loss propersities, and we show that the use of such categorization may permit the attainment of first-best allocations as competitive Nash equilibria. The optimal insurance premium involves a trade-off between the use of categorization to correct moral hazard externalities generated by the consumption of the product and the use of differential consumption to sort heterogeneous consumers, thereby mitigating the social costs of adverse selection. The efficiency consequences of taxing or subsidizing aggregate, as opposed to individual, consumption is also considered.