The Welfare Effects of Contestability in Insurance

We study an insurance model characterized by a continuum of risk types, private information and a competitive supply side. We investigate the contestability clause in the policy: when a claim is filed, the insurer may dispute it on grounds of the information provided by the insuree. Smoking in life insurance is our leading example: there are different rates for smokers and non-smokers. We compare the aggregate utility in a two contracts economy with a one, non-contestable contract economy. Having two contracts alleviates adverse selection, but increases the risk in the smokers pool. The negative effect dominates: contestability decreases welfare.