Adverse selection is often seen as a major impediment to the efficient functioning of insurance markets. Rothschild and Stiglitz (1976) create a model where high risk people buy full insurance while low risk individuals buy partial insurance. Yet empirically, one finds that in some insurance markets, low risk individuals purchase more insurance than high risk individuals.

An NBER working paper by Cutler, Finkelstein and McGarry (2008) claims that preference heterogeneity may explain this phenomenon. If low-risk individuals also have a stronger risk aversion preferences, than they may buy more insurance than a high-risk individual who has risk loving preferences. This work is an extension of the Finkelstein and McGarry (AER 2006) article discussed in one of my earlier blog posts.

Using data from the Health and Retirement Study (HRS), the authors measure risk tolerance using the following variables: smoking, having 3+ alcoholic drinks per day, job-based mortality risk, receipt of preventive health services, and seat belt usage. The authors find a negative relationship between individuals who engage in risky behavior (i.e., smoking, drinking, and those working in a high-risk occupation) and the percent who purchase various types of insurance, and a positive relationship between those engage in risk reducing behavior (i.e., preventive medical care, seat belt usage) and the purchase of insurance.

Smoking Drinking Job Risk Prev. care Seat belt Life Ins – – – + + Annuity – o – + + Long-term care o o – + + Medigap – o – + + Health Ins – – – + +

In the above chart, ‘+’ represents a positive statistically significant correlation, ‘-‘ represents a negative statistically significant correlation, and o indicates that the relationship is not statistically significant.

The authors can also measure risk preferences based on respondents answers to income gamble questions. There is a weak relationship between risk preferences and risk behavior however.

The authors confirm that risk behavior lead to an increased probability of adverse events which would be covered by insurance. For instance, smoking increases mortality which would lead to an earlier life insurance payout. Increased preventive health activities decrease the probability of a nursing home stay.

Thus the authors conclude the following:

Our analysis yields two main findings. First, in all five markets, we find that individuals who engage in what are commonly thought of as risky behaviors (smoking, drinking, or prior employment in jobs with higher mortality rates) or who do not take measures to thought to reduce risk (preventive health activities or wearing of a seat belt) are systematically less likely to hold each of these insurance products. Second, we find that these same individuals tend to have higher expected claims for life insurance and long term care insurance, but lower expected claims for annuities; for Medigap and acute health insurance, there is no systematic relationship between the behavior measures and expected claims.

These results can help to explain the puzzle of insurance we started with: why is adverse selection not more common? In annuity markets, there is clear evidence of adverse selection: people who live longer are more likely to buy insurance. The standard adverse selection model is one explanation for this, but so is variation in risk tolerance; people who have less risky behaviors live longer and are more likely to buy annuities. In life insurance, our results suggest that differential risk tolerance can help explain why people with lower mortality rates have more insurance. Similarly, in the case of long-term care insurance, people who use more preventive care or are more likely to wear seat belts buy insurance more readily but also stay out of nursing homes.