Regulating Genetic Information in Insurance Markets

The debate on whether insurance companies should be allowed to use results of genetic tests for underwriting purposes is both lively and increasingly relevant as both technology and lawmaking efforts are progressing rapidly. In this article we outline the primary economic and non-economic arguments made in favor of and against allowing insurers to risk-rate premiums on the basis of genetic test results. While economic analysis has much to offer in enlightening this debate and informing policy makers, we argue that such work must be cast within the overall perspective of the genetic testing debate. Moreover, despite substantial strides by economists in understanding the role of information in the way insurance markets operate, much work still needs to be done in order for economic analysis to be confidently applied to the looming social issues of the continuing genetic revolution.     

First-Best Equilibrium in Insurance Markets With Transaction Costs and Heterogeneity

We investigate extensions of the classic Rothschild and Stiglitz (1976) (RS) model of adverse selection under asymmetric information. In RS, low‐risk customers are worse off owing to an externality created by high‐risk buyers in the market. We find critical changes in insurance buyers' behavior under the joint assumptions of transaction costs and buyer heterogeneity with respect to either risk aversion or wealth. Combining transaction costs and heterogeneity, we find a separating equilibrium in which neither high‐risk nor low‐risk individuals are penalized due to information asymmetry.     

Regulation of Insurance Markets

There have been major changes in the way European insurance markets are regulated, and there is still considerable debate about what the form and scope of regulation should be. This article examines the arguments for solvency regulation when consumers are fully informed of the insurer's insolvency risk. It is shown firms always provide enough capital to ensure solvency, unless there are restrictions on the composition of their asset portfolios. The conclusion holds even when competition means that only normal profits can be earned. This suggests that the role of regulation in insurance markets should be confined to providing consumers with information about the default risk of insurers.     

Tort Reform and Insurance Markets

Proposed tort reforms have focused on punitive damages and noneconomic damages, each of which pose problems for jury decision making. The U.S. Supreme Court decision in State Farm v. Campbell will greatly limit very large punitive damages awards, and will affect smaller punitive awards to a lesser degree. Noneconomic damages caps enacted by state legislatures have greatly enhanced insurance market performance. Insurers operate within the context of a highly imperfect, regulated market in which there is substantial price rigidity induced by regulation. Reform efforts should strive to establish greater predictability and stability in these awards components rather than simply being concerned with imposing specific numerical caps.     

Testing for Asymmetric Information in Insurance Markets: A Multivariate Ordered Regression Approach

The positive correlation (PC) test is the standard procedure used in the empirical literature to detect the existence of asymmetric information in insurance markets. This article describes a new tool to implement an extension of the PC test based on a new family of regression models, the multivariate ordered logit, designed to study how the joint distribution of two or more ordered response variables depends on exogenous covariates. We present an application of our proposed extension of the PC test to the Medigap health insurance market in the United States. Results reveal that the risk–coverage association is not homogeneous across coverage and risk categories, and depends on individual socioeconomic and risk preference characteristics.     

Arbitrage and Viability in Insurance Markets

Insurance markets are subject to transaction costs and constraints on portfolio holdings. Therefore, unlike the frictionless asset markets case, viability is not equivalent to absence of arbitrage possibilities. We use the concept of unbounded arbitrage to characterize viable prices on a complete and an incomplete insurance market. In the complete market, there is an insurance contract for every possible event. In the incomplete market, risk can be insured through proportional and excess of loss like insurance contracts. We show how the the structure of viable prices is affected by the portfolio constraints, the transaction costs, and the structure of marketed contracts.     

Price Regulation in Secondary Insurance Markets

Secondary life insurance markets are growing rapidly. From nearly no transactions in 1980, a wide variety of similar products in this market has developed, including viatical settlements, accelerated death benefits, and life settlements and as the population ages, these markets will become increasingly popular. Eight state governments, in a bid to guarantee sellers a “fair” price, have passed regulations setting a price floor on secondary life insurance market transactions, and more are considering doing the same. Using data from a unique random sample of HIV+ patients, we estimate welfare losses from transactions prevented by binding price floors in the viatical settlements market (an important segment of the secondary life insurance market). We find that price floors bind on HIV patients with greater than 4 years of life expectancy. Furthermore, HIV patients from states with price floors are significantly less likely to viaticate than similarly healthy HIV patients from other states. If price floors were adopted nationwide, they would rule out transactions worth $119 million per year. We find that the magnitude of welfare loss from these blocked transactions would be highest for consumers who are relatively poor, have weak bequest motives, and have a high rate of time preference.     

Contracting with Present-Biased Consumers in Insurance Markets

Present bias challenges consumers with self-control problems when they implement precautionary efforts in insurance markets. To explore how rational insurance companies respond to this bias, this paper analyzes a contract design problem in a monopolistic insurance market with ex ante moral hazard. We consider two types of consumers with this bias: the “naifs”, who do not foresee the present bias and make decisions in a myopic way, and the “sophisticates”, who foresee the bias and incorporate it in the decision process. Relative to the benchmark case where consumers are time-consistent, we show that (i) present bias reduces the monopoly profit, regardless of the consumer type; (ii) present bias can either reduce or increase the coverage of the profit-maximizing insurance contract depending on the extent of the bias; and (iii) when present bias is severe, the insurance company can profitably exploit naifs but not sophisticates. These results still hold when consumers are heterogeneous and their types are unknown to the insurance company.     

Strategic Price Discrimination in Compulsory Insurance Markets

This paper considers price discrimination when competing firms do not observe a customer’s type but only some other variable correlated to it. This is a typical situation in many insurance markets—such as motor insurance—where it is also often the case that insurance is compulsory. We characterise the equilibria and their welfare properties under various price regimes. We show that discrimination based on immutable characteristics such as gender is a dominant strategy, either when firms offer policies at a fixed price or when they charge according to some consumption variable that is correlated to costs. In the latter case, gender discrimination can be an outcome of strategic interaction alone in situations where it would not be adopted by a monopolist. Strategic price discrimination may also increase cross subsidies between types, contrary to expectations.JEL Classification No.: L13, G22     

The Problem of Asymmetric Information: A Simulation of How Insurance Markets Can Be Inefficient

The concept of adverse selection is discussed in virtually all academic insurance textbooks. However, undergraduate students have rarely had the experience of purchasing insurance which may limit their ability to fully comprehend the market inefficiencies created by asymmetric information. We provide a classroom simulation of an insurance market that highlights the concept of adverse selection and its impact on the insurance industry. Participants are asked to make insurance decisions in pursuit of their own interests under different market conditions. In the absence of perfect information, participants actively observe that a socially optimal outcome does not occur.     

Testing for Adverse Selection in Insurance Markets

This article reviews and evaluates the empirical literature on adverse selection in insurance markets. We focus on empirical work that seeks to test the basic coverage–risk prediction of adverse selection theory—that is, that policyholders who purchase more insurance coverage tend to be riskier. The analysis of this body of work, we argue, indicates that whether such a correlation exists varies across insurance markets and pools of insurance policies. We discuss various reasons why a coverage–risk correlation may not be found in some pools of insurance policies. The presence of a coverage–risk correlation can be explained either by moral hazard or adverse selection, and we discuss methods for distinguishing between them. Finally, we review the evidence on learning by policyholders and insurers.     

Risk Mutualization and Competition in Insurance Markets

The aim of this paper is to analyze the impact of mutual firms on competition in the insurance market. We distinguish two actors in this market: mutual firms, which belong to their pooled members, and traditional companies, which belong to their shareholders. Our approach differs from the literature by one crucial assumption: the expected utility of the consumers depends on the size of their insurance firm, which generates network externalities in this market. Thus, the choice of a contract results in a trade-off between the premium level and the probability of that premium being ex-post adjusted. The optimal contract offered by a mutual firm involves a systematic ex-post adjustment (negative or positive), while the contracts a company offers imply a fixed premium that is possibly negatively adjusted at the end of the contractual period. In an oligopoly game, we show that three types of configurations are possible at equilibrium: either one mutual firm or insurance company is active, or a mixed structure emerges in which two or more companies share the market with or without a mutual firm.     

Multidimensional Screening in Insurance Markets with Adverse Selection

Bundled coverage of different losses and distinct perils, along with differential deductibles and policy limits, are common features of insurance contracts. We show that, through these practices, insurers can implement multidimensional screening of insurance applicants who possess hidden knowledge of their risks, and thereby reduce the externality cost of adverse selection. Competitive forces drive insurers to exploit multidimensional screening, enhancing the efficiency of insurance contracting. Moreover, multidimensional screening allows competitive insurance markets to attain pure strategy Nash equilibria over a wider range of applicant pools, resolving completely the Rothschild–Stiglitz nonexistence puzzle in markets where the perils space is sufficiently divisible.     

On the Role of Patience in an Insurance Market With Asymmetric Information

We analyze a two-period competitive insurance market that is characterized by the simultaneous presence of moral hazard and adverse selection with regard to consumer time preferences. It is shown that there exists an equilibrium in which patient consumers use high effort and buy an insurance contract with high coverage, whereas impatient consumers use low effort and buy a contract with low coverage or even remain uninsured. This finding may help to explain why the opposite of adverse selection with regard to risk types can sometimes be observed empirically.