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Unformatted text preview: 157 American Economic Review: Papers & Proceedings 2008, 98:2, 157162 http://www.aeaweb.org/articles.php?doi = 10.1257/aer.98.2.157 The textbook approach to insurance markets emphasizes the role of private information about risk in determining who purchases insurance. In the classic adverse selection model of Michael Rothschild and Joseph Stiglitz (1976), individu- als with higher expected claims buy more insur- ance than those with lower expected claims, who may be out of the market entirely. This basic prediction of asymmetric information models of a positive correlation between insurance cov- erage and accident occurrence has been shown to be robust to a variety of extensions to the stan- dard framework (Pierre-Andr Chiappori and Bernard Salanie 2000; Chiappori et al. 2006). In practice, however, insurance markets differ substantially in whether higher-risk individuals or lower-risk individuals have more coverage. In acute health insurance markets and in annu- ity markets, for example, the preponderance of evidence suggests that higher-risk people have more insurance, as the standard theory would predict. However, the opposite is true in life insurance, long-term care insurance, and Medigap markets, which tend to exhibit either no selection or advantageous selectionthose who have more insurance are lower risk. 1 Such advantageous selection has been detected even in cases where individuals have private infor- mation about their risk type that is positively 1 See, e.g., Finkelstein and James M. Poterba (2004) on annuities, John Cawley and Tomas Philipson (1999) on life insurance, Finkelstein and McGarry (2006) on long- term care insurance, Hanming Fang, Michael Keane, and Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance By David M. Cutler, Amy Finkelstein, and Kathleen McGarry* correlated with insurance demand (Finkelstein and McGarry 2006). Indeed, the discrepancy between theory and reality is even more striking, given that moral hazard would tend to increase the risk occurrence of those with more coverage, even in the absence of adverse selection. One explanation for this puzzle is that indi- viduals may vary in their tolerance for risk, in addition to their exogenous risk status. When individuals are heterogeneous in their prefer- ences as well as their risk type, the relationship between insurance coverage and risk occurrence can be of any sign (e.g., Chiappori et al. 2006). For example, individuals with lower tolerance for risk may not only demand more insurance but may also invest in activities that lower their expected claims, leading the lower risk to have more coverage. In this case, the insurance market may exhibit over-insurance relative to the first best, rather than the under-insurance of classic adverse selection models (David de Meza and David C. Webb 2001). In other situations, the standard adverse selection result may prevail....
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This note was uploaded on 04/04/2011 for the course ECON 3301 taught by Professor Staff during the Spring '08 term at UT Arlington.
- Spring '08