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.
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). Contact details of provider: Postal: University of Connecticut 341 Mansfield Road, Unit 1063 Storrs, CT 06269-1063 Phone: (860) 486-4889 Fax: (860) 486-4463 Web page: http://www.econ.uconn.edu/ More information through EDIRC
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
David M. Cutler & Richard J. Zeckhauser, 1998.
"Adverse Selection in Health Insurance,"
NBER Chapters,
in: Frontiers in Health Policy Research, volume 1, pages 1-32
National Bureau of Economic Research, Inc.
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