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Does Propitious Selection Explain Why Riskier People Buy Less Insurance?

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  • De Donder, Philippe
  • Hindriks, Jean J.G.

Abstract

Empirical testing of asymmetric information in the insurance market has uncovered a negative correlation between risk levels and insurance purchases, rather than the positive correlation predicted by the standard insurance theory. Hemenway (1990) proposes an explanation for this negative correlation, called 'propitious selection''. He argues that potential insurance buyers have different tastes for risk and that 'individuals who are highly risk avoiding are more likely both to try to reduce the hazard and to purchase insurance' (p. 1064). Chiappori and Salanié (2000) also suggest that this line of argument, which they call 'cherry picking', may explain the observed negative correlation. In this paper, we show that the propitious selection argument does not imply negative correlation between risk levels and insurance purchases, be-cause it fails to take into account the supply side of the insurance market. To illustrate this claim, we provide a model where, although we assume that individuals differ in risk aversion and that the more risk averse individuals exert more precaution and buy more insurance, we end up with a positive correlation between risk and insurance purchases at equilibrium. The reason is that, in any separating equilibrium, the more risk averse individuals face insurance overprovision which, combined with moral hazard, increases their risk relative to the less risk averse individuals. To obtain the negative correlation between risk and insurance purchases, one further needs the extra condition of decreasing marginal willingness to pay for the less risk averse individuals. Finally, we find that propitious selection has profound policy implications for social insurance.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5640.

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Date of creation: Apr 2006
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Handle: RePEc:cpr:ceprdp:5640

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Keywords: cherry picking; precaution; preference-based adverse selection; social insurance;

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References

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  1. Jean Hindriks & Philippe De Donder, 2001. "The Politics of Redistributive Social Insurance," Working Papers 444, Queen Mary, University of London, School of Economics and Finance.
  2. Jullien, Bruno & Salanié, Bernard & Salanié, François, 2001. "Screening Risk Averse Agents Under Moral Hazard," CEPR Discussion Papers 3076, C.E.P.R. Discussion Papers.
  3. Pierre-Andre Chiappori & Bernard Salanie, 2000. "Testing for Asymmetric Information in Insurance Markets," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 56-78, February.
  4. Bruno Jullien & Bernard Salanié & François Salanié, 1998. "Should More Risk-Averse Agents Exert More Effort," Working Papers 98-12, Centre de Recherche en Economie et Statistique.
  5. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
  6. Tomas Philipson & John Cawley, 1999. "An Empirical Examination of Information Barriers to Trade in Insurance," American Economic Review, American Economic Association, vol. 89(4), pages 827-846, September.
  7. de Meza, David & Webb, David C, 2001. "Advantageous Selection in Insurance Markets," RAND Journal of Economics, The RAND Corporation, vol. 32(2), pages 249-62, Summer.
  8. Hemenway, David, 1992. " Propitious Selection in Insurance," Journal of Risk and Uncertainty, Springer, vol. 5(3), pages 247-51, July.
  9. Amy Finkelstein & Kathleen McGarry, 2003. "Private Information and its Effect on Market Equilibrium: New Evidence from Long-Term Care Insurance," NBER Working Papers 9957, National Bureau of Economic Research, Inc.
  10. Louis Eeckhoudt & Christian Gollier, 2005. "The impact of prudence on optimal prevention," Economic Theory, Springer, vol. 26(4), pages 989-994, November.
  11. Hemenway, David, 1990. "Propitious Selection," The Quarterly Journal of Economics, MIT Press, vol. 105(4), pages 1063-69, November.
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Cited by:
  1. Alma Cohen & Peter Siegelman, 2010. "Testing for Adverse Selection in Insurance Markets," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 77(1), pages 39-84.
  2. Nick Netzer & Florian Scheuer, 2006. "Competitive Screening in Insurance Markets with Endogenous Labor Supply," Discussion Papers of DIW Berlin 614, DIW Berlin, German Institute for Economic Research.
  3. Stanciole, Anderson, 2007. "Health Insurance and Life Style Choices: Identifying the Ex Ante Moral Hazard," IRISS Working Paper Series 2007-10, IRISS at CEPS/INSTEAD.
  4. Hultkrantz, Lars & Lindberg, Gunnar, 2009. "Pay-as-you-speed:An economic field-experiment," Working Papers 2009:8, Swedish National Road & Transport Research Institute (VTI).
  5. Tsvetanka Karagoyozova & Peter Siegelman, 2006. "Is There Propitious Selection in Insurance Markets?," Working papers 2006-20, University of Connecticut, Department of Economics.

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