Liquidity Constraints and the Value of Insurance

42 Pages Posted: 17 Sep 2018

See all articles by Keith M. Marzilli Ericson

Keith M. Marzilli Ericson

Boston University - Markets, Public Policy, and Law; National Bureau of Economic Research (NBER)

Justin R. Sydnor

University of Wisconsin - Madison

Date Written: September 2018

Abstract

Insurance affects the variability of consumption over time, which is not captured in standard expected utility of wealth models. We develop a consumption-utility model that shows how liquidity constraints and borrowing costs impact the value of insurance. Liquidity constraints generate high insurance demand when premiums are due smoothly, sometimes leading to seemingly dominated choices. Conversely, a risk-averse person may value insurance below its expected value and appear risk loving when premiums are due in a single payment. Moreover, optimal insurance contracts take different forms with liquidity constraints. We show empirical insurance analysis using the standard model can generate misleading counterfactuals and welfare estimates. Finally, we demonstrate the model’s feasibility and importance with an application to evaluating cost-sharing reductions on the health insurance exchanges.

Suggested Citation

Ericson, Keith M. Marzilli and Sydnor, Justin R., Liquidity Constraints and the Value of Insurance (September 2018). NBER Working Paper No. w24993. Available at SSRN: https://ssrn.com/abstract=3246815

Keith M. Marzilli Ericson (Contact Author)

Boston University - Markets, Public Policy, and Law ( email )

Boston, MA
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Justin R. Sydnor

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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