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Non-monotone insurance contracts and their empirical consequences

Listed author(s):
  • Aloisio Araujo


  • Humberto Moreira


    (Department of Economics PUC-Rio)

The goal of this paper is to show the possibility of a non-monotone relation between coverage ans risk which has been considered in the literature of insurance models since the work of Rothschild and Stiglitz (1976). We present an insurance model where the insured agents have heterogeneity in risk aversion and in lenience (a prevention cost parameter). Risk aversion is described by a continuous parameter which is correlated with lenience and for the sake of simplicity, we assume perfect correlation. In the case of positive correlation, the more risk averse agent has higher cosr of prevention leading to a higher demand for coverage. Equivalently, the single crossing property (SCP) is valid and iplies a positive correlation between overage and risk in equilibrium. On the other hand, if the correlation between risk aversion and lenience is negative, not only may the SCP be broken, but also the monotonocity of contracts, i.e., the prediction that high (low) risk averse types choose full (partial) insurance. In both cases riskiness is monotonic in risk aversion, but in the last case there are some coverage levels associated with two different risks (low and high), which implies that the ex-ante (with respect to the risk aversion distribution) correlation between coverage and riskiness may have every sign (even though the ex-post correlation is always positive). Moreover, using another instrument (a proxy for riskiness), we give a testable implication to desentangle single crossing ans non single croosing under an ex-post zero correlation result: the monotonicity of coverage as a function os riskiness. Since by controlling for risk aversion (no asymmetric information), coverage is monotone function of riskiness, this also fives a test for asymmetric information. Finally, we relate this theoretical results to empirical tests in the recent literature, specially the Dionne, Gouruéroux and Vanasse (2001) work. In particular, they found an empirical evidence that seems to be c

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Paper provided by Department of Economics PUC-Rio (Brazil) in its series Textos para discussão with number 449.

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Length: 32 pages
Date of creation: Dec 2001
Handle: RePEc:rio:texdis:449
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