Dynamic Insurance and Adverse Selection

We take a dynamic perspective on insurance markets under adverse selection and study a generalized Rothschild and Stiglitz model where agents may differ with respect to the accidental probability and their expenditure levels in case an accident occurs. We investigate the nature of dynamic insurance contracts by considering both conditional and unconditional dynamic contracts. An unconditional dynamic contract has insurance companies offering contracts where the terms of the contract depend on time, but not on the occurrence of past accidents. Conditional dynamic contracts make the actual contract also depend on individual past performance (like in car insurances). We investigate whether allowing insurance companies to offer dynamic insurance contracts results in Pareto- improvements over static contracts. Our main results are as follows. When agents only differ in their accidental expenditures, then dynamic insurance contracts yield a welfare improvement only if dynamic contracts are conditional on past performance. When, however, agents' expenditures differ just a little bit dynamic insurance contracts are strictly Pareto improving even for unconditional dynamic contracts.