ADVANTAGEOUS SELECTION, MORAL HAZARD, AND INSURER SORTING ON RISK IN THE U.S. AUTOMOBILE INSURANCE MARKET

• Date: 01 June 2018
• Author: Patricia A. Robinson,Frank A. Sloan,Lindsey M. Eldred
• DOI: http://doi.org/10.1111/jori.12170
• Published date: 01 June 2018

ADVANTAGEOUS SELECTION,MORAL HAZARD,AND

INSURER SORTING ON RISK IN THE U.S. AUTOMOBILE

INSURANCE MARKET

Patricia A. Robinson

Frank A. Sloan

Lindsey M. Eldred

ABSTRACT

This study quantifies the role of private information in automobile insurance

policy choice using data on subjective beliefs, risk preference, reckless

driving, the respondent’s insurer, and insurance policy characteristics

merged with insurer-specific quality ratings distributed by independent

organizations. We find a zero correlation between ex post accident risk and

insurance coverage, reflecting advantageous selection in policy choice offset

by moral hazard. Advantageous selection is partly attributable to insurer

sorting on consumer attributes known and used by insurers. Our analysis of

insurer sorting reveals that lower-risk drivers on attributes observed by

insurers obtain coverage from insurers with higher-quality ratings.

INTRODUCTION

Empirical studies of insurance purchase decisions have demonstrated that consumers

possess private information when purchasing, and their private information comes in

multidimensional forms (e.g., Fang, Keane, and Silverman, 2008). This information

pertains to risk types (Rothchild and Stiglitz, 1976), but also preferences, such as risk

aversion, thrill seeking, tastes for goods leading to risk taking, for example, alcohol,

and in subjective beliefs about adverse consequences of risky behaviors. Individuals

also differ in cognitive ability, which affects knowledge of the law and adverse

consequences of risky behaviors, and, for driving, in their altruism toward other

Patricia A. Robinson, Frank A. Sloan, and Lindsey M. Eldred are at the Department of

Economics, Duke University, 213 Social Sciences Building, Box 90097, Durham, NC 27708.

Sloan can be contacted via e-mail: fsloan@duke.edu. This article was funded in part by a grant

from the National Institute on Alcohol Abuse and Alcoholism (NIAAA, #R01AA017913-01A1).

The sponsor had no role in the design or conduct of this study. There are no conflicts of interest

or any financial disclosures for any of the authors. The Duke University Institutional Review

Board approved the survey. We also thank Hanming Fang, University of Pennsylvania, and

Ahmed Khwaja, Yale University, for their collaboration in writing the proposal that led to the

grant and for assistance in developing the questionnaire used in this study.

© 2016 The Journal of Risk and Insurance. Vol. 85, No. 2, 545–575 (2018).

DOI: 10.1111/jori.12170

545

drivers, and in driving skills. While research has documented that multidimensional

sources of private information exist, much remains to be learned about what these

sources are and how they vary by insurance type, and how they affect functioning

of insurance markets.

Even though private information is a source of adverse selection in insurance markets

and the notion that purchasers of insurance possess some private information is

widely accepted, not all studies have found adverse selection (e.g., Cohen and

Siegelman, 2010). A frequently used method for determining whether there is adverse

selection is the positive correlation test, where the correlation is between insurance

quantity purchased and losses incurred during the policy year. Several studies of

automobile insurance have reported a zero correlation between insurance coverage

and accident risk (Chiappori and Salanie, 2000; Dionne, Gourieroux, and Vanasse,

2001; Saito, 2006).

1

A deficiency of this test is that a positive correlation can reflect both

adverse selection and moral hazard. Disentangling the two is not straightforward (de

Meza and Webb, 2001; Bajari et al., 2014). Also, a zero correlation may reflect

multidimensional private information (Finkelstein and McGarry, 2006).

In the standard model of insurance choice, insurers are passive agents. Insurance

markets persist in the presence of private information and with government

requirements that certain types of information known to insurers not be explicitly

used in premium setting or underwriting. Insurers must have learned how to cope

with such private information. Yet research on this topic is still in its infancy (Baker

and Swedlof, 2013).

This study uses unique data from a survey of persons who both drove and consumed

alcohol conducted for our research in four U.S. states—North Carolina, Pennsylvania,

Washington, and Wisconsin. Our survey obtained information on various sources of

private information, for example, respondents’ subjective probabilities about

engaging in future behaviors and of experiencing adverse driving outcomes; risk

preference; other preferences including altruism, income, wealth, motor vehicle

ownership, and respondents’ driving habits; and demographic characteristics. The

survey asked for the respondent’s automobile insurer and amounts of third-party and

first-party insurance the person had, and the premium paid. Having the automobile

insurer’s name, we merge quality ratings obtained from several independent sources

with the survey data. To our knowledge, no prior study has had as much information

on insurance purchasers and choices as we do. A major strength of our survey is that it

obtained objective measures of risk at the follow-up interview that are comparable to

measures of subjective beliefs obtained at baseline about a year earlier, which allows

for within-sample comparisons.

We find that there is advantageous selection in choice of automobile liability

insurance coverage, and there is moral hazard. The advantageous selection reflects

market responses on the supply side. In particular, risks are segmented based on

1

The above studies are based on North American data. In a German study, correlations were

either zero or small and positive (Spindler, Winter, and Hagmayer, 2014). Positive correlations

were found in studies using French (Chiappori et al., 2006) and Israeli (Cohen, 2005) data.

546 THE JOURNAL OF RISK AND INSURANCE