Selection and asymmetric information in insurance markets.

• Author: Einav, Liran
• Position: Research Summaries

Since the seminal theoretical work of Arrow, Akerlof, and Rothschild and Stiglitz, economists have been aware of the potential for market failures arising from the existence of asymmetric information in private insurance markets. The possibility that competitive forces may not push toward efficiency in such a large and important class of markets creates interesting and difficult economic and policy issues. It also poses a challenge for empirical research: identifying and quantifying the effects of asymmetric information and tracing its implications for welfare, competition, and government policy.

The empirical research in this area has advanced rapidly over the past decade. However, although providing valuable descriptive information about the workings of an insurance market, tests for whether asymmetric information actually exists in particular insurance markets and in what form have some important limitations. Notably, without a clear mapping from patterns in the data to underlying economic primitives, the tests are relatively uninformative about the extent of market inefficiency or the welfare impact of potential market interventions.

Motivated by these concerns, we and our coauthors have written a series of papers that attempt to incorporate theoretically grounded specifications of consumer preferences and firms' pricing into this analysis. Our models can be used to quantify both the welfare distortions arising from asymmetric information and the potential welfare consequences of such government policies as mandates, pricing restrictions, and taxes. Our approach takes its cues from descriptive findings in the initial testing literature, in particular by seeking to incorporate rich heterogeneity in consumer preferences, as well as the heterogeneity in risk emphasized by the classic theoretical contributions.

In this article we summarize some of our own recent work and findings. A less self-centered discussion of these topics can be found in our recent overview article. (1)

Determinants of Insurance Demand

Why do individuals place different values on insurance coverage? Much of the seminal theoretical work assumed that individuals only varied along one dimension, their expected risk. Some individuals face greater risk and therefore are willing to pay more for insurance. For example, all else equal, older and sicker individuals would be willing to pay more for health and life insurance; individuals who commute long distances would be willing to pay more for auto insurance; and retirees with greater life expectancy would place a higher valuation on annuities. If risk (or some component of it) is private information to the individual, then adverse selection can result.

At the heart of these contributions on adverse selection is the idea that at a given price of insurance, buying insurance is more attractive for riskier individuals. This is the same idea that subsequently guided early empirical attempts to test for the existence of asymmetric information, focusing on comparing claims rates for consumers who...