Does propitious selection explain why riskier people buy less insurance? (original) (raw)

Empirical Evidence for Advantageous Selection in the Insurance Market

2000

  1. indicated that individuals with a higher degree of risk aversion would demand more insurance and invest in self-protection to reduce risk probability when both the preference type and investment in self-protection are hidden from insurers. They referred to the negative correlation between market insurance and risk type as advantageous selection. However, the relationship between risk type and the degree of risk aversion is debatable in both theoretical and empirical research. This paper therefore proposes that advantageous selection could be supported from another angle by directly examining the relationships that exist among market insurance, selfprotection, and risk probability. By focusing on the commercial fire insurance market, information on the purchase of market insurance, investment in self-protection, and fire accident records is hand-collected by means of a unique survey. It is found that firms purchasing market insurance have a greater tendency to channel efforts into selfprotection. It is also found that firms expending effort on self-protection are less likely to suffer a fire accident. Furthermore, it is found that firms with commercial fire insurance have less chance of suffering a fire accident than those without such insurance. Each of the above three findings jointly supports the view that advantageous selection could play a critical role in the commercial fire insurance market.

Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance

American Economic Review, 2008

Standard theories of insurance, dating from , stress the role of adverse selection in explaining the decision to purchase insurance. In these models, higher risk people buy full or near-full insurance, while lower risk people buy less complete coverage, if they buy at all. While this prediction appears to hold in some real world insurance markets, in many others, it is the lower risk individuals who have more insurance coverage. If the standard model is extended to allow individuals to vary in their risk tolerance as well as their risk type, this could explain why the relationship between insurance coverage and risk occurrence can be of any sign, even if the standard asymmetric information effects also exist. We present empirical evidence in five difference insurance markets in the United States that is consistent with this potential role for risk tolerance. Specifically, we show that individuals who engage in risky behavior or who do not engage in risk reducing behavior are systematically less likely to hold life insurance, acute private health insurance, annuities, long-term care insurance, and Medigap. Moreover, we show that the sign of this preference effect differs across markets, tending to induce lower risk individuals to purchase insurance in some of these markets, but higher risk individuals to purchase insurance in others. These findings suggest that preference heterogeneity may be important in explaining the differential patterns of insurance coverage in various insurance markets.

Experimental Tests of Self-Selection and Screening in Insurance Decisions

The Geneva Papers on Risk and Insurance Theory, 1999

A major characteristic of insurance markets is information asymmetry that may lead to phenomena such as adverse selection and moral hazard. Another aspect of markets with asymmetric information is self-selection, which refers to the pattern of choices that individuals with different personal characteristics make when facing a menu of contracts or options. To combat problems of asymmetric information, insurance firms can use screening. That is, they can offer the clients a menu of choices and infer their characteristics from their choices. This article reports the results of several studies that examined the degree to which people behave according to the notions of self-selection and screening. Subjects played the role of either insurance buyers or sellers. The results of these studies provide partial support for the hypothesis that subjects use self-selection and screening in insurance markets. Our study also points at the importance of learning in experimental studies. In one-stage experiments where subjects did not get feedback, screening was not detected. When multistage experiments were conducted, and the subjects learned from experience and were also taught the relevant theories, their decisions were more aligned with screening.

Selection in Insurance Markets: Theory and Empirics in Pictures

Journal of Economic Perspectives, 2011

We present a graphical framework for analyzing both theoretical and empirical work on selection in insurance markets. We begin by using this framework to review the "textbook" adverse selection environment and its implications for insurance allocation, social welfare, and public policy. We then discuss several important extensions to this classical treatment that are necessitated by important real world features of insurance markets and which can be easily incorporated in the basic framework. Finally, we use the same graphical approach to discuss the intuition behind recently developed empirical methods for testing for the existence of selection and examining its welfare consequences. We conclude by discussing some important issues that are not well-handled by this framework and which, perhaps not unrelatedly, have been little addressed by the existing empirical work.

Empirical Evidence for Advantageous Selection in the Commercial Fire Insurance Market*

The Geneva Risk and Insurance Review, 2009

  1. indicated that individuals with a higher degree of risk aversion would demand more insurance and invest in self-protection to reduce risk probability when both the preference type and investment in self-protection are hidden from insurers. They referred to the negative correlation between market insurance and risk type as advantageous selection. However, the relationship between risk type and the degree of risk aversion is debatable in both theoretical and empirical research. This paper therefore proposes that advantageous selection could be supported from another angle by directly examining the relationships that exist among market insurance, selfprotection, and risk probability. By focusing on the commercial fire insurance market, information on the purchase of market insurance, investment in self-protection, and fire accident records is hand-collected by means of a unique survey. It is found that firms purchasing market insurance have a greater tendency to channel efforts into selfprotection. It is also found that firms expending effort on self-protection are less likely to suffer a fire accident. Furthermore, it is found that firms with commercial fire insurance have less chance of suffering a fire accident than those without such insurance. Each of the above three findings jointly supports the view that advantageous selection could play a critical role in the commercial fire insurance market.

Regulating Consumer Demand in Insurance Markets

In recent years it has become increasingly clear that risk aversion cannot by itself explain how and why individuals purchase insurance. From the perspective of risk aversion, individuals tend to purchase insurance when they should not, refuse to purchase insurance when they should, prefer sub-optimal payouts, and allow irrelevant considerations to infl uence their insurance preferences. This article considers the normative implications of these 'insurance demand anomalies'. It argues that many observed deviations from traditional theory are likely the result of mistakes, in the sense that consumers would act differently if they possessed perfect information and cognitive resources. From this perspective, regulatory interventions designed to improve consumer decision-making about insurance are potentially desirable. At the same time, the article argues that some insurance demand anomalies may actually refl ect sophisticated consumer behaviour. In some cases, seemingly puzzling insurance decisions may help consumers manage emotions such as anxiety, regret and loss aversion, while in other cases they may represent valuable commitment strategies. Because consumers' insurance decisions may refl ect sophisticated rather than mistaken decision-making, regulatory interventions that limit consumer choice are normatively troubling. Given these confl icting explanations for risk aversion's failure as a descriptive theory of consumer demand in insurance markets, the article explores a spectrum of 'libertarian-paternalistic' regulatory interventions. It argues that regulatory strategies that aim to encourage presumptively welfare-maximising insurance decisions without restricting individual choice represent a promising and normatively defensible opportunity for improving consumer behaviour in insurance markets.

Are Risk Preferences Stable across Contexts? Evidence from Insurance Data

American Economic Review, 2011

Using a unique dataset, we test whether households' deductible choices in auto and home insurance reflect stable risk preferences. Our test relies on a structural model that assumes households are objective expected utility maximizers and claims are generated by household-coverage specific Poisson processes. We find that the hypothesis of stable risk preferences is rejected by the data. Our analysis suggests that many households exhibit greater risk aversion in their home deductible choices than their auto deductible choices. Our results are robust to several alternative modeling assumptions. (JEL D11, D83)

Insurance and portfolio decisions: Two sides of the same coin?

Journal of Financial Economics, 2023

We study insurance and portfolio decisions, two opposite risk retention tradeoffs. Using household level data, we identify the first joint determinants (e.g. subjective expectations, risk attitude) and frictions (e.g. liquidity constraints, financial literacy) in the literature. We also find key differences between the two decisions. Notably, contrary to economic intuition, risky asset holding and insurance coverage both increase with wealth. We show that this apparent puzzle is driven in part by a specific behavioral pattern (the poor invest too conservatively, while the rich over-insure), and can be explained by two factors: regret avoidance and nonperformance risk.