Does Propitious Selection Explain Why Riskier People Buy Less Insurance?
AbstractEmpirical 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 InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5640.
Date of creation: Apr 2006
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Other versions of this item:
- De Donder, Philippe & Hindriks, Jean, 2006. "Does Propitious Selection Explain why Riskier People buy less Insurance?," IDEI Working Papers 399, Institut d'Économie Industrielle (IDEI), Toulouse.
- Philippe, DE DONDER & Jean, HINDRIKS, 2006. "Does Propitious Selection Explain why Riskier People Buy less Insurance," Discussion Papers (ECON - DÃ©partement des Sciences Economiques) 2006017, Université catholique de Louvain, Département des Sciences Economiques.
- DE DONDER, Philippe & HINDRIKS, Jean, 2006. "Does propitious selection explain why riskier people buy less insurance?," CORE Discussion Papers 2006032, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-05-06 (All new papers)
- NEP-EVO-2006-05-06 (Evolutionary Economics)
- NEP-FIN-2006-05-06 (Finance)
- NEP-FMK-2006-05-06 (Financial Markets)
- NEP-IAS-2006-05-06 (Insurance Economics)
- NEP-UPT-2006-05-06 (Utility Models & Prospect Theory)
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