Preference Heterogeneity and Insurance Markets: Explaining a Puzzle of Insurance.

The textbook approach to insurance markets emphasizes the role of private information about risk in determining who purchases insurance. In the classic adverse selection model of Michael Rothschild and Joseph Stiglitz (1976), individuals with higher expected claims buy more insurance than those with lower expected claims, who may be out of the market entirely. This basic prediction of asymmetric information models of a “positive correlation” between insurance coverage and accident occurrence has been shown to be robust to a variety of extensions to the standard framework (Pierre-André Chiappori and Bernard Salanie 2000; Chiappori et al. 2006). In practice, however, insurance markets differ substantially in whether higher-risk individuals or lower-risk individuals have more coverage. In acute health insurance markets and in annuity markets, for example, the preponderance of evidence suggests that higher-risk people have more insurance, as the standard theory would predict. However, the opposite is true in life insurance, long-term care insurance, and Medigap markets, which tend to exhibit either no selection or “advantageous selection”—those who have more insurance are lower risk. Such advantageous selection has been detected even in cases where individuals have private information about their risk type that is positively