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The Welfare Cost of Asymmetric Information: Evidence from the U.K. Annuity Market

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  • Liran Einav
  • Amy Finkelstein
  • Paul Schrimpf
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    Abstract

    Much of the extensive empirical literature on insurance markets has focused on whether adverse selection can be detected. Once detected, however, there has been little attempt to quantify its importance. We start by showing theoretically that the efficiency cost of adverse selection cannot be inferred from reduced form evidence of how "adversely selected" an insurance market appears to be. Instead, an explicit model of insurance contract choice is required. We develop and estimate such a model in the context of the U.K. annuity market. The model allows for private information about risk type (mortality) as well as heterogeneity in preferences over different contract options. We focus on the choice of length of guarantee among individuals who are required to buy annuities. The results suggest that asymmetric information along the guarantee margin reduces welfare relative to a first-best, symmetric information benchmark by about £127 million per year, or about 2 percent of annual premiums. We also find that government mandates, the canonical solution to adverse selection problems, do not necessarily improve on the asymmetric information equilibrium. Depending on the contract mandated, mandates could reduce welfare by as much as £107 million annually, or increase it by as much as £127 million. Since determining which mandates would be welfare improving is empirically difficult, our findings suggest that achieving welfare gains through mandatory social insurance may be harder in practice than simple theory may suggest.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13228.

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    Date of creation: Jul 2007
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    Handle: RePEc:nbr:nberwo:13228

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    Cited by:
    1. George-Levi Gayle & Limor Golan & Robert A. Miller, . "Promotion, Turover and Compensation in the Executive Market," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 2008-E32, Carnegie Mellon University, Tepper School of Business.
    2. Liran Einav & Amy Finkelstein & Mark R. Cullen, 2008. "Estimating Welfare in Insurance Markets Using Variation in Prices," NBER Working Papers 14414, National Bureau of Economic Research, Inc.
    3. Duarte, Fabian, 2012. "Price elasticity of expenditure across health care services," Journal of Health Economics, Elsevier, Elsevier, vol. 31(6), pages 824-841.
    4. Mark Cullen & Liran Einav & Amy Finkelstein, 2008. "Estimating Welfare in Insurance Markets Using Variation in Prices," Discussion Papers, Stanford Institute for Economic Policy Research 08-006, Stanford Institute for Economic Policy Research.
    5. Alma Cohen & Peter Siegelman, 2010. "Testing for Adverse Selection in Insurance Markets," Journal of Risk & Insurance, The American Risk and Insurance Association, The American Risk and Insurance Association, vol. 77(1), pages 39-84.
    6. Jeffrey Clemens, 2014. "Regulatory Redistribution in the Market for Health Insurance," NBER Working Papers 19904, National Bureau of Economic Research, Inc.
    7. Huang, Rachel J. & Tsai, Jeffrey T. & Tzeng, Larry Y., 2008. "Government-provided annuities under insolvency risk," Insurance: Mathematics and Economics, Elsevier, vol. 43(3), pages 377-385, December.
    8. Amy Finkelstein, 2011. "Comment on "The Demand for Medicare Part D Prescription Drug Coverage: Evidence from Four Waves of the Retirement Perspectives Survey"," NBER Chapters, National Bureau of Economic Research, Inc, in: Explorations in the Economics of Aging, pages 182-185 National Bureau of Economic Research, Inc.
    9. Amy Finkelstein, 2010. "Comment on "Mind the Gap! Consumer Perceptions and Choices of Medicare Part D Prescription Drug Plans"," NBER Chapters, National Bureau of Economic Research, Inc, in: Research Findings in the Economics of Aging, pages 481-484 National Bureau of Economic Research, Inc.

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