Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance

20 Pages Posted: 24 Jan 2008 Last revised: 25 Jul 2010

See all articles by David M. Cutler

David M. Cutler

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Harvard University - Harvard Kennedy School (HKS)

Amy Finkelstein

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Kathleen M. McGarry

University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: January 2008

Abstract

Standard theories of insurance, dating from Rothschild and Stiglitz (1976), stress the role of adverse selection in explaining the decision to purchase insurance. In these models, higher risk people buy full or near-full insurance, while lower risk people buy less complete coverage, if they buy at all. While this prediction appears to hold in some real world insurance markets, in many others, it is the lower risk individuals who have more insurance coverage. If the standard model is extended to allow individuals to vary in their risk tolerance as well as their risk type, this could explain why the relationship between insurance coverage and risk occurrence can be of any sign, even if the standard asymmetric information effects also exist. We present empirical evidence in five difference insurance markets in the United States that is consistent with this potential role for risk tolerance. Specifically, we show that individuals who engage in risky behavior or who do not engage in risk reducing behavior are systematically less likely to hold life insurance, acute private health insurance, annuities, long-term care insurance, and Medigap. Moreover, we show that the sign of this preference effect differs across markets, tending to induce lower risk individuals to purchase insurance in some of these markets, but higher risk individuals to purchase insurance in others. These findings suggest that preference heterogeneity may be important in explaining the differential patterns of insurance coverage in various insurance markets.

Suggested Citation

Cutler, David M. and Finkelstein, Amy and McGarry, Kathleen M., Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance (January 2008). NBER Working Paper No. w13746. Available at SSRN: https://ssrn.com/abstract=1086997

David M. Cutler (Contact Author)

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Amy Finkelstein

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Kathleen M. McGarry

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