Automobile Insurance and Driver Ability: Contract Choice as a Screening Mechanism

We analyze whether allowing the choice between full tort and limited tort coverage can serve as a screening mechanism in automobile insurance markets with asymmetric information. We show that limited tort policies create an externality on the market. Using a model of price competition where menus of contracts can be offered, and drivers choose their level of safety effort, we show that there can exist a separating equilibrium where low risks choose full tort contracts and high risks choose limited tort contracts. There also can exist pooling equilibria at the full tort or the limited tort contracts. We show that equilibria without limited tort policies and equilibria that include limited tort policies are mutually exclusive. We also show that, relative to an exclusively full tort system, a choice system is no worse and leads to a Pareto improvement if a separating or limited tort pooling equilibrium is obtained.