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Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance

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  • David M. Cutler
  • Amy Finkelstein
  • Kathleen McGarry

Abstract

Standard theories of insurance, dating from Rothschild and Stiglitz (1976), stress the role of adverse selection in explaining the decision to purchase insurance. In these models, higher risk people buy full or near-full insurance, while lower risk people buy less complete coverage, if they buy at all. While this prediction appears to hold in some real world insurance markets, in many others, it is the lower risk individuals who have more insurance coverage. If the standard model is extended to allow individuals to vary in their risk tolerance as well as their risk type, this could explain why the relationship between insurance coverage and risk occurrence can be of any sign, even if the standard asymmetric information effects also exist. We present empirical evidence in five difference insurance markets in the United States that is consistent with this potential role for risk tolerance. Specifically, we show that individuals who engage in risky behavior or who do not engage in risk reducing behavior are systematically less likely to hold life insurance, acute private health insurance, annuities, long-term care insurance, and Medigap. Moreover, we show that the sign of this preference effect differs across markets, tending to induce lower risk individuals to purchase insurance in some of these markets, but higher risk individuals to purchase insurance in others. These findings suggest that preference heterogeneity may be important in explaining the differential patterns of insurance coverage in various insurance markets.

(This abstract was borrowed from another version of this item.)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.157
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 98 (2008)
Issue (Month): 2 (May)
Pages: 157-62

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Handle: RePEc:aea:aecrev:v:98:y:2008:i:2:p:157-62

Note: DOI: 10.1257/aer.98.2.157
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References

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  1. Bruno Jullien & Bernard Salanié & François Salanié, 2000. "Screening Risk-Averse Agents Under Moral Hazard," Working Papers 2000-41, Centre de Recherche en Economie et Statistique.
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  16. Ettner, Susan L., 1997. "Adverse selection and the purchase of Medigap insurance by the elderly," Journal of Health Economics, Elsevier, vol. 16(5), pages 543-562, October.
  17. B. Douglas Bernheim & Lorenzo Forni & Jagadeesh Gokhale & Laurence J. Kotlikoff, 2001. "The mismatch between life insurance holdings and financial vulnerabilities: evidence from the Health and Retirement Survey," Working Paper 0109, Federal Reserve Bank of Cleveland.
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