Working Paper: NBER ID: w22773
Authors: Hanming Fang; Zenan Wu
Abstract: A large empirical literature found that the correlation between insurance purchase and ex post realization of risk is often statistically insignificant or negative. This is inconsistent with the predictions from the classic models of insurance a la Akerlof (1970), Pauly (1974) and Rothschild and Stiglitz (1976) where consumers have one-dimensional heterogeneity in their risk types. It is suggested that selection based on multidimensional private information, e.g., risk and risk preference types, may be able to explain the empirical findings. In this paper, we systematically investigate whether selection based on multidimensional private information in risk and risk preferences, can, under different market structures, result in a negative correlation in equilibrium between insurance coverage and ex post realization of risk. We show that if the insurance market is perfectly competitive, selection based on multidimensional private information does not result in negative correlation property in equilibrium, unless there is a sufficiently high loading factor. If the insurance market is monopolistic or imperfectly competitive, however, we show that it is possible to generate negative correlation property in equilibrium when risk and risk preference types are sufficiently negative dependent, a notion we formalize using the concept of copula. We also clarify the connections between some of the important concepts such as adverse/advantageous selection and positive/negative correlation property.
Keywords: insurance; multidimensional private information; market structure; adverse selection; advantageous selection
JEL Codes: D82; G22; H11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| multidimensional private information (D82) | negative correlation between insurance coverage and ex post risk realizations (G52) |
| sufficiently high loading factor (L90) | negative correlation between insurance coverage and ex post risk realizations (G52) |
| risk types and risk preference types negatively dependent (D81) | negative correlation property in monopolistic markets (D42) |