A Study of the Interaction of Insurance and Financial Markets: Efficiency and Full Insurance Coverage

José S. Penalva

No 286, Working Papers from Barcelona School of Economics

Abstract: The first contribution of this paper is to provide a framework, a model together with a corresponding equilibrium notion, suitable for the study of the interaction between insurance and dynamic financial markets. This framework is used to prove the central result in the paper: in equilibrium agents purchase full insurance coverage, despite insurance prices that are not actuarially fair. The paper identifies three conditions which together explain why buying full insurance is optimal for any risk-averse individual even in the presence of loaded insurance prices: (i) insurance contracts are priced competitively, (ii) financial prices include a risk premium only for undiversifiable risk, and (iii) financial markets are effectively complete. An implication is that in this model disasters can be insured by fully reserved stock insurance companies.

Date: 2003-05
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