European Economic Review 11, 1978, pp. 321-341.
The task of this paper is to examine whether insurance markets can be expected to work efficiently and, if necessary, how they could be improved. Our analysis concentrates on the rote of the insured parties who are assumed to choose among insurance contracts offered to them by the company and, simultaneously, among activities which enable them to change the loss distributions which the company would bear, at least to some extent. lt can often be observed that these activities are selected in such a way that after buying insurance, losses tend to be higher than before. We shall study systematically four important mechanisms for this phenomenon (sections 2.2.3, 2.2.4, 3 and 4) and attempt to evaluate them from the welfare point of view. Surprisingly enough, the analysis will show that it is not always true that the insurance induced increase in losses indicates misallocation, as one could suppose at first glance and as it is suggested by the term 'moral hazard' which is sometimes used in this connection.