Does Propitious Selection Explain Why Riskier People Buy Less Insurance?

21 Pages Posted: 19 Jul 2006

See all articles by Philippe De Donder

Philippe De Donder

University of Toulouse 1 - Toulouse School of Economics (TSE)

Jean Hindriks

University of London - School of Economics and Finance

Date Written: April 2006

Abstract

Empirical testing of asymmetric information in the insurance market has uncovered a negative correlation between risk levels and insurance purchases, rather than the positive correlation predicted by the standard insurance theory. Hemenway (1990) proposes an explanation for this negative correlation, called "propitious selection". He argues that potential insurance buyers have different tastes for risk and that "individuals who are highly risk avoiding are more likely both to try to reduce the hazard and to purchase insurance" (p. 1064). Chiappori and SalaniƩ (2000) also suggest that this line of argument, which they call "cherry picking", may explain the observed negative correlation. In this paper, we show that the propitious selection argument does not imply negative correlation between risk levels and insurance purchases, because it fails to take into account the supply side of the insurance market. To illustrate this claim, we provide a model where, although we assume that individuals differ in risk aversion and that the more risk averse individuals exert more precaution and buy more insurance, we end up with a positive correlation between risk and insurance purchases at equilibrium. The reason is that, in any separating equilibrium, the more risk averse individuals face insurance overprovision which, combined with moral hazard, increases their risk relative to the less risk averse individuals. To obtain the negative correlation between risk and insurance purchases, one further needs the extra condition of decreasing marginal willingness to pay for the less risk averse individuals. Finally, we find that propitious selection has profound policy implications for social insurance.

Keywords: Preference-based adverse selection, cherry picking, precaution, social insurance

JEL Classification: D82, G22

Suggested Citation

De Donder, Philippe and Hindriks, Jean, Does Propitious Selection Explain Why Riskier People Buy Less Insurance? (April 2006). CEPR Discussion Paper No. 5640, Available at SSRN: https://ssrn.com/abstract=918277

Philippe De Donder (Contact Author)

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Jean Hindriks

University of London - School of Economics and Finance ( email )

Mile End Road
London, E1 4NS
United Kingdom
+44 20 7882 7807 (Phone)
+44 20 8983 3580 (Fax)

HOME PAGE: http://www.dc.eclipse.co.uk/hindriks.html

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