Insurer Contract Nonperformance in a Market with Adverse Selection

In this study we examine the impact of insurer contract nonperformance upon Wilson's adverse selection equilibrium where consumers exhibit constant absolute risk aversion. When the market equilibrium retains its original form (i.e., pool or separation), premiums and coverage levels generally fall, although the change in coverage level for good risks is ambiguous when the equilibrium is separating. When the market equilibrium changes form, the change in premium and coverage levels is generally ambiguous, although one can determine that good risk premiums go down when the equilibrium shifts from pooling to separating and that bad risk premiums and coverage levels go down when the equilibrium shifts from separating to pooling. Interestingly, we find that although the introduction of insurer default risk makes good risks worse off, this is not necessarily true for bad risks. Bad risks can be better off because the decrease in the price differential between types can make pooling relatively more attractive to good risks in the presence of default risk.