Adverse Selection, Aggregate Uncertainty, and the Role for Mutual Insurance Contracts

A model of insurance markets analogous to that of Rothschild and Stiglitz (1976) is considered, with the additional feature that risk-neutral insurers face aggregate (undiversifiable) risk. In the presence of adverse selection and aggregate uncertainty and under a simple nondegeneracy condition on loss probabilities, the authors show that any equilibrium has the feature that some agents purchase participating policies (from mutual insurers) while others purchase nonparticipating policies (and, hence, do not share risk with their insurer). Specifically, agents with low loss probabilities signal their type by sharing aggregate risks with their insurer. Some empirical support for this prediction is provided.