Unlucky or Risky? Unobserved Heterogeneity and Experience Rating in Insurance Markets
Cornell University - Department of Economics
Darcy Steeg Morris
Government of the United States of America - Bureau of the Census
Joshua C. Teitelbaum
Georgetown University Law Center
November 14, 2012
Georgetown Law and Economics Research Paper No. 12-040
We investigate whether an insured's claims experience contains valuable information about its latent risk type. Using data on households' claims histories in auto and home insurance, we estimate the variance-covariance matrix of unobserved heterogeneity and utilize the estimates to update a priori predictions about the households' claim risk. The estimates reveal that unobserved heterogeneity is positively correlated across coverages. We then explore how households' demand for insurance would respond to experience rating under different theories of risky choice. We conclude that the potential for experience rating to meliorate adverse selection depends crucially on the sources of insureds' aversion to risk.
Number of Pages in PDF File: 55
Keywords: adverse selection, claim rates, experience rating, insurance law, risk type, unobserved heterogeneity
JEL Classification: C58, D12, D82, G22, K23working papers series
Date posted: November 16, 2012
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