An Insurance Market Simulation With Both Adverse and Advantageous Selection

AuthorPuneet Jaiprakash,Leon Chen
Date01 March 2017
DOIhttp://doi.org/10.1111/rmir.12070
Published date01 March 2017
Risk Management and Insurance Review
C
Risk Management and Insurance Review, 2017, Vol.20, No. 1, 133-146
DOI: 10.1111/rmir.12070
EDUCATIONAL INSIGHTS
ANINSURANCE MARKET SIMULATION WITH BOTH
ADVERSE AND ADVANTAGEOUS SELECTION
Leon Chen
Puneet Jaiprakash
ABSTRACT
The theory of adverse selection predicts that high-risk individuals are more
likely to buy insurance than low-risk individuals if asymmetric information
regarding individuals’ risk type is present in the market. The theory of ad-
vantageous selection predicts the opposite—a negative relationship between
insurance coverage and risk type can be obtained when hidden knowledge in
other dimensions (e.g., the degree of risk aversion) is present in addition to
the risk type. Using the heterogeneity of insurance buyers in either risk type or
risk aversion, we first introduce a classroom-based insurance market simulation
game to show that adverse selection and advantageous selection can coexist.
We then explain the underlying concepts using two methods: a mathematical
framework based on expected utility theory and an empirical framework based
on the results of the game itself. The game is easy to implement, reinforces text-
book concepts by providing students a hands-on experience, and supplements
current textbooks by bringing their content up to date with current research.
INTRODUCTION
Theoretical and empirical research in the field of asymmetric information has made sig-
nificant progress in the past few decades. In an influential paper,Rothschild and Stiglitz
(1976) (RS hereafter) show that in the presence of asymmetric information between the
insurance buyers and sellers, high (low) risk buyers will purchase more (less) coverage.
Their model of adverse selection predicts a positive correlation between insurance cov-
erage and the ex post realization of a buyer’s risk, measured by the number of claims,
total payouts, etc. In the RS model, there may be no equilibrium in competitive insur-
ance markets. Empirical tests of their model find a positive correlation in some insurance
markets such as health insurance (Cardon and Hendel, 2001) and annuities (Finkelstein
and Poterba, 2004), and a negative correlation in other markets such as life insurance
(Cawley and Philipson, 1999), long-term care (Finkelstein and McGarry, 2006), reverse
Leon Chen is Associate Professor of Finance, Minnesota State University Mankato, phone: 507-
389-5336; e-mail: yilin.chen@mnsu.edu. Puneet Jaiprakash is Associate Professor of Finance,
Minnesota State University Mankato, phone: 507-389-1826; e-mail: puneet.jaiprakash@mnsu.edu.
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