Working Paper: NBER ID: w24993
Authors: Keith Marzilli Ericson; Justin R. Sydnor
Abstract: Liquidity constraints create preferences over how insurance contracts move money across both time and states because insurance can have a consumption-smoothing benefit. We incorporate liquidity constraints into a model in which insurance contracts span multiple consumption periods. We show that the insurance demand of rational liquidity-constrained individuals will differ qualitatively and quantitatively from the standard model’s normative benchmarks: they will not fully insure at actuarially fair prices when premiums are paid upfront, they may purchase insurance even when premiums are so high that insurance is dominated in the standard model, and they may pay to insure against events that are certain to happen. We provide simulations showing that liquidity constrained individuals will systematically violate normative benchmarks in ways that have been previously documented and interpreted as mistakes. We also provide new survey evidence that liquidity-constrained individuals are more likely to express a preference for dominated insurance plans, even when the standard rationale for avoiding such plans is explained. We discuss how liquidity constraints can affect the optimal design of partial insurance and highlight the need to account for liquidity when evaluating insurance demand.
Keywords: liquidity constraints; insurance demand; consumption smoothing; risk transfer
JEL Codes: D01; D15; D81; G22; I13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Liquidity constraints (E51) | Lower demand for insurance (G52) |
| Upfront premiums (G22) | Lower demand for insurance (G52) |
| Liquidity constraints (E51) | Risk-loving behavior under certain conditions (D81) |
| Liquidity constraints (E51) | Optimal design of insurance contracts (G52) |
| Liquidity constraints (E51) | Preference for dominated insurance plans (G52) |