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Is There Propitious Selection in Insurance Markets?

  • Tsvetanka Karagoyozova

    (University of Connecticut)

  • Peter Siegelman

    (University of Connecticut)

The theory of adverse selection in insurance markets has been enormously influential among scholars, regulators, and the judiciary. But empirical support for adverse selection has been much less persuasive, and several recent studies have found little or no evidence of such selection in insurance markets. "Propitious" (advantageous) selection offers an alternative mechanism that is consistent with these empirical findings. Like adverse selection, the theory assumes that insureds have an informational advantage over insurers. However, propitious selection relies on the plausible assumption that risk aversion is negatively correlated with the riskiness or probability of loss across insureds - the more risk-averse are also the more careful, and hence are least likely to experience a loss. Theorists have recognized the possibility of equilibria in which highly risk averse insureds with a low probability of loss are willing to remain in the market, despite an actuarially unfair premium. But these conclusions derive from models with only two types of insureds. We use a simulation model that allows for flexible correlation between risk aversion and riskiness across a continuum of types, with plausible distributions of risk aversion and riskiness. We find that propitious selection alone can not preserve equilibrium in insurance markets. When insureds have moderate uncertainty about their own riskiness, however, equilibrium does become possible, albeit with considerable selection.

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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2006-20.

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Length: 40 pages
Date of creation: Nov 2006
Date of revision:
Handle: RePEc:uct:uconnp:2006-20
Note: We thank seminar participants at the University of Connecticut,Wesleyan University and UC Berkeley Law School for useful comments. We would also like to thank Tom Baker, Set Chandler, Dhammika Dharmapala, Kathleen Segerson, Dan Silverman, Christian Zimmermann and especially Jill Horwitz for comments and encouragement. Any remaining conceptual or other errors are our fault. Part of this work was completed while Siegelman was visiting at the University of Michigan Law School (Spring 2006).
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  1. David M. Cutler & Richard J. Zeckhauser, 1997. "Adverse Selection in Health Insurance," NBER Working Papers 6107, National Bureau of Economic Research, Inc.
  2. John Cawley & Tomas Philipson, 1997. "An Empirical Examination of Information Barriers to Trade inInsurance," University of Chicago - George G. Stigler Center for Study of Economy and State 132, Chicago - Center for Study of Economy and State.
  3. Luigi Guiso & Monica Paiella, 2008. "Risk Aversion, Wealth, and Background Risk," Journal of the European Economic Association, MIT Press, vol. 6(6), pages 1109-1150, December.
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  5. Hanming Fang & Michael P. Keane & Dan Silverman, 2008. "Sources of Advantageous Selection: Evidence from the Medigap Insurance Market," Journal of Political Economy, University of Chicago Press, vol. 116(2), pages 303-350, 04.
  6. Dohmen, Thomas J & Falk, Armin & Huffman, David & Schupp, Jürgen & Sunde, Uwe & Wagner, Gert Georg, 2006. "Individual Risk Attitudes: New Evidence from a Large, Representative, Experimentally-Validated Survey," CEPR Discussion Papers 5517, C.E.P.R. Discussion Papers.
  7. Alma Cohen & Liran Einav, 2007. "Estimating Risk Preferences from Deductible Choice," American Economic Review, American Economic Association, vol. 97(3), pages 745-788, June.
  8. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
  9. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
  10. Christian Gollier, 2004. "The Economics of Risk and Time," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262572249, June.
  11. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
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