Testing for Asymmetric Information Using “Unused Observables” in Insurance Markets: Evidence from the U.K. Annuity Market

• Date: 01 December 2014
• Author: Amy Finkelstein,James Poterba
• Published date: 01 December 2014
• DOI: http://doi.org/10.1111/jori.12030

TESTING FOR ASYMMETRIC INFORMATION USING “UNUSED

OBSERVABLES”IN INSURANCE MARKETS:EVIDENCE FROM

THE U.K. ANNUITY MARKET

Amy Finkelstein

James Poterba

ABSTRACT

This article tests for asymmetric information in the U.K. annuity market of

the 1990s by trying to identify “unused observables,” attributes of individual

insurance buyers that are correlated both with subsequent claims experience

and with insurance demand but that insurance companies did not use to set

insurance prices. Unlike the widely used positive correlation test for

asymmetric information, which searches for a positive correlation between

insurance demand and risk experience, the unused observables test is not

confounded by heterogeneity in individual preference parameters that may

affect insurance demand. We identify residential location as an unused

observable in the U.K. annuity market of this period. Even though residential

location was observed by all market participants, the decision not to

condition prices on it created the same types of market inefficiencies that

arise when annuity buyers have private information about mortality risk.

Our findings raise questions about how insurance companies select the set of

buyer attributes that they use in setting policy prices. In the decade following

the period that we study, U.K. insurance companies changed their pricing

practices and began to condition annuity prices on a buyer’s postcode.

Amy Finkelstein and James Poterba are at the Department of Economics, MIT, 77

Massachusetts Avenue, E17-214, Cambridge, MA 02139. They can be contacted via e-mail:

afink@mit.edu and poterba@mit.edu. The authors are also affiliated with the National Bureau

of Economic Research. They thank Edmund Cannon, Pierre-Andre Chiappori, Richard Disney,

Liran Einav, Carl Emmerson, Michael Orszag, Casey Rothschild, Ian Tonks, Michael

Wadsworth, Jonathan Zinman, and especially Jeff Brown and Keith Crocker for helpful

comments and encouragement; Hui Shan for outstanding research assistance; the National

Institute of Aging and the National Science Foundation (Poterba) for financial support; and the

generous employees at the firm that provided the data for this study. Poterba is a trustee of the

College Retirement Equity Fund (CREF) and of the TIAA-CREF mutual funds, entities that sell

retirement saving products including annuities.

© The Journal of Risk and Insurance, 2014, Vol. 81, No. 4, 709–734

DOI: 10.1111/j.1539-6975.2013.12030.x

709

INTRODUCTION

Asymmetric information is widely recognized as hindering the efficient operation of

insurance markets, but whether it is present in specific markets remains a subject of

active research. In recent years, numerous studies have tested for asymmetric

information in a variety of different insurance markets. This work has been largely

based on the “positive correlation” test described by Chiappori and Salanie (2000).

This test rejects the null hypothesis of symmetric information when there is a positive

correlation between insurance purchases and risk occurrence, conditional on the

buyer characteristics that are used to set insurance prices.

A limitation of the positive correlation test, noted by Finkelstein and McGarry (2006)

and Chiappori et al. (2006), is that it breaks down when individuals have private

information about characteristics other than risk type, such as risk preferences, and

when these other characteristics affect insurance demand. A number of studies,

reviewed by Cutler, Finkelstein, and McGarry (2008) and by Einav, Finkelstein, and

Levin (2010), suggest that this type of preference heterogeneity plays an empirically

important role in many insurance markets.

This article illustrates an alternative, and quite straightforward, test for asymmetric

information that is robust to the existence of preference heterogeneity in insurance

demand. When some attributesof insurance buyers that are correlated with insurance

demand and subsequent risk experienceare not used to price insurance policies, then

insurance buyers effectively have private information about their risk type. This may

occur even when insurance companies observe, or could observe, the relevant

individual characteristics, but choose not to use them in pricing. We refer to this

situation as one of “asymmetrically used” information to distinguishit from the more

classic “asymmetric information” that results when features of the contracting

environment make it impossible forthe insurer to observe risk-relevant characteristics

of consumers. Asymmetrically used information has similar implications for market

equilibrium and market efficiency as the more classic “asymmetric information.”

We test for asymmetrically used information by asking if we can identify individual

characteristics that are risk relevant and correlated with insurance demand, but that

are not used by insurance companies in designing the contract menus facing

individuals. We refer to this as the “unused observables” test.

Regulation can be one source of “asymmetric use” of information in insurance

markets. When insurance companies are prevented from using some individual

characteristics in pricing insurance policies, buyers who know these characteristics

and their relationship to risk type can exploit this information. In many insurance

markets, however, asymmetrically used information occurs because insurance

companies voluntarily choose not to price on the basis of risk-related buyer

information that they collect, or could collect. We explore this ostensible puzzle in

more detail below. We suggest that concerns about regulatory response and

consumer backlash may contribute to this behavior, but we stop short of providing

any evidence to support this conjecture.

We illustrate the use of the unused observables test in the retirement annuity market

in the United Kingdom in the 1990s. In the United Kingdom, those who saved for

710 THE JOURNAL OF RISK AND INSURANCE