Endogenous categorization in insurance

This paper analyzes the welfare properties of equilibrium when insurers use observable actions to classify consumers into different risk categories, and consumers' choice is influenced by the insurance market consequences of their actions. Specifically, we analyze this problem at the example of a car insurance market, in which individual preferences over car types are correlated with risk type and used by insurance firms for ratemaking. Equilibrium premiums for each car are determined by the losses that it generates. Consumers take insurance premiums into account when deciding which car to buy. This creates an incentive to buy the car that is preferred by more low risk individuals. From a utilitarian point of view, this incentive is excessive. Depending on parameters, it may even be possible to construct a tax-subsidy scheme with balanced budget that Pareto improves on the market equilibrium.