The purpose of this study is to determine the characteristics of the equilibrium between demand and supply for a reciprocal insurance firm.
The model developed assumes a fixed number of individuals with identical characteristics and of constant absolute risk aversion who can choose between remaining self‐insured or forming a reciprocal insurer to serve their needs.
The results show that under those conditions the individuals either remain self‐insured or form a reciprocal and buy full insurance. Which of the two decisions will be made depends on the relation between the number of members of the reciprocal and the expenses that will be incurred by that entity.
Most alternative models of insurance demand imply that, in the presence of transaction costs, partial insurance is the rule.
The major practical implication is that there can be serious agency problems in the management of reciprocals if attorneys‐in‐fact have influence over their salaries, since they may be able to increase their private welfare at the expense of that of the policyholders.
The model is new and its practical implications have not been discussed previously.
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