Testing for Adverse Selection with "Unused Observables"

Amy Finkelstein and James Poterba ()

No 12112, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper proposes a new test for adverse selection in insurance markets based on observable characteristics of insurance buyers that are not used in setting insurance prices. The test rejects the null hypothesis of symmetric information when it is possible to find one or more such %u201Cunused observables%u201D that are correlated both with the claims experience of the insured and with the quantity of insurance purchased. Unlike previous tests for asymmetric information, this test is not confounded by heterogeneity in individual preference parameters, such as risk aversion, that affect insurance demand. Moreover, it can potentially identify the presence of adverse selection, while most alternative tests cannot distinguish adverse selection from moral hazard. We apply this test to a new data set on annuity purchases in the United Kingdom, focusing on the annuitant%u2019s place of residence as an %u201Cunused observable.%u201D We show that the socio-economic status of the annuitant%u2019s place of residence is correlated both with annuity purchases and with the annuitant%u2019s prospective mortality. Annuity buyers in different communities therefore face different effective insurance prices, and they make different choices accordingly. This is consistent with the presence of adverse selection. Our findings also raise questions about how insurance companies select the set of buyer attributes that they use in setting policy prices. We suggest that political economy concerns may figure prominently in decisions to forego the use of some information that could improve the risk classification of insurance buyers.

JEL-codes: D82 G22 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm, nep-fin, nep-fmk and nep-ias
Date: 2006-03
Note: AP PE POL
View list of references View citations in EconPapers

Downloads: (external link)
http://www.nber.org/papers/w12112.pdf (application/pdf)
Access to the full text is generally limited to series subscribers, however if the top level domain of the client browser is in a developing country or transition economy free access is provided. More information about subscriptions and free access is available at http://www.nber.org/wwphelp.html.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:nbr:nberwo:12112

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w12112
The price is Paper copy available by mail.

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc
Address: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Contact information at EDIRC.
Series data maintained by ().