Journal of Economic Perspectives—Volume 25, Number 1—Winter 2011—Pages 115–138 Selection in Insurance Markets: Theory and Empirics in Pictures Liran Einav and Amy Finkelstein rromom tthehe llarge-scalearge-scale ssocialocial iinsurancensurance pprogramsrograms ooff SSocialocial SSecurityecurity aandnd MMedi-edi- ccareare ttoo tthehe hheavilyeavily rregulatedegulated pprivaterivate mmarketsarkets fforor ppropertyroperty aandnd ccasualtyasualty F iinsurance,nsurance, ggovernmentovernment iinterventionntervention iinn iinsurancensurance mmarketsarkets iiss uubiquitous.biquitous. TThehe ffundamentalundamental ttheoreticalheoretical rreasoneason fforor ssuchuch iintervention,ntervention, bbasedased oonn cclassiclassic wworkork ffromrom tthehe 11970s,970s, iiss tthehe pproblemroblem ooff aadversedverse sselection.election. BButut ddespiteespite tthehe aagege aandnd iinflnfl uuenceence ooff tthehe theory,theory, systematicsystematic empiricalempirical examinationexamination ofof selectionselection inin actualactual insuranceinsurance mmarketsarkets isis a relativelyrelatively recentrecent development.development. Indeed,Indeed, inin awardingawarding thethe 20012001 NobelNobel PPrizerize forfor thethe pioneeringpioneering theoreticaltheoretical workwork onon asymmetricasymmetric informationinformation toto GeorgeGeorge AAkerlof,kerlof, MichaelMichael Spence,Spence, andand JosephJoseph Stiglitz,Stiglitz, thethe NobelNobel committeecommittee notednoted thisthis ppaucityaucity ofof empiricalempirical workwork (Nobelprize.org,(Nobelprize.org, 2001).2001). OOverver tthehe llastast ddecade,ecade, hhowever,owever, eempiricalmpirical wworkork oonn sselectionelection iinn iinsurancensurance mmarketsarkets hhasas ggainedained cconsiderableonsiderable mmomentum,omentum, aandnd a ffairlyairly eextensivextensive ((andand sstilltill ggrowing)rowing) eempiricalmpirical lliteratureiterature oonn tthehe ttopicopic hhasas eemerged.merged. TThishis rresearchesearch hhasas ffoundound tthathat aadversedverse sselectionelection eexistsxists iinn ssomeome iinsurancensurance mmarketsarkets bbutut nnotot iinn oothers.thers. IItt hhasas aalsolso uuncoveredncovered eexamplesxamples ooff mmarketsarkets tthathat eexhibitxhibit ““advantageousadvantageous sselection”—aelection”—a pphenomenonhenomenon nnotot cconsideredonsidered bbyy tthehe ooriginalriginal ttheory,heory, aandnd oonene tthathat hhasas ddifferentifferent cconsequencesonsequences fforor eequilibriumquilibrium iinsurancensurance aallocationllocation aandnd ooptimalptimal ppublicublic ppolicyolicy tthanhan tthehe cclassicallassical ccasease ooff aadversedverse sselection.election. RResearchersesearchers hhaveave aalsolso ttakenaken sstepsteps ttowardoward eestimatingstimating tthehe wwelfareelfare cconsequencesonsequences ooff ddetectedetected sselectionelection aandnd ooff ppotentialotential ppublicublic ppolicyolicy iinterventions.nterventions. ■ LLiraniran EEinavinav iiss AAssociatessociate PProfessorrofessor ooff EEconomics,conomics, SStanfordtanford UUniversity,niversity, SStanford,tanford, California.California. AAmymy FFinkelsteininkelstein iiss PProfessorrofessor ofof Economics,Economics, MassachusettsMassachusetts InstituteInstitute ofof Technology,Technology, Cambridge,Cambridge, MMassachusetts.assachusetts. BothBoth aauthorsuthors areare aalsolso ResearchResearch Associates,Associates, NationalNational BureauBureau ofof EconomicEconomic RResearch,esearch, CCambridge,ambridge, Massachusetts.Massachusetts. TheirTheir ee-mail-mail aaddressesddresses aarere 〈[email protected]@stanford.edu〉 aandnd 〈aafifi [email protected]@mit.edu〉. doi=10.1257/jep.25.1.115 116 Journal of Economic Perspectives IInn tthishis essay,essay, wwee ppresentresent a graphicalgraphical fframeworkramework fforor analyzinganalyzing bothboth theoreticaltheoretical aandnd eempiricalmpirical wworkork oonn sselectionelection iinn iinsurancensurance mmarkets.arkets. TThishis ggraphicalraphical approach,approach, wwhichhich ddrawsraws hheavilyeavily oonn a ppaperaper wwee wrotewrote wwithith MarkMark CullenCullen ((Einav,Einav, Finkelstein,Finkelstein, andand CCullen,ullen, 22010),010), pprovidesrovides bothboth a usefuluseful aandnd iintuitiventuitive depictiondepiction ofof thethe basicbasic theorytheory ofof sselectionelection aandnd iitsts iimplicationsmplications fforor wwelfareelfare andand ppublicublic policy,policy, aass wwellell asas a llensens tthroughhrough wwhichhich oonene ccanan uunderstandnderstand thethe ideasideas aandnd llimitationsimitations ooff eexistingxisting eempiricalmpirical workwork onon tthishis ttopic.opic. WWee bbeginegin bbyy uusingsing tthishis fframeworkramework toto reviewreview thethe “textbook”“textbook” adverseadverse selectionselection eenvironmentnvironment aandnd iitsts iimplicationsmplications fforor iinsurancensurance aallocation,llocation, ssocialocial wwelfare,elfare, aandnd ppublicublic ppolicy.olicy. WWee tthenhen ddiscussiscuss sseveraleveral iimportantmportant eextensionsxtensions toto thisthis cclassiclassic treatmenttreatment thatthat areare nnecessitatedecessitated bbyy iimportantmportant rreal-worldeal-world ffeatureseatures ooff iinsurancensurance marketsmarkets aandnd wwhichhich ccanan bbee eeasilyasily iincorporatedncorporated iinn tthehe basicbasic framework.framework. Finally,Finally, wewe useuse thethe samesame graphicalgraphical aapproachpproach ttoo ddiscussiscuss tthehe iintuitionntuition bbehindehind rrecentlyecently ddevelopedeveloped eempiricalmpirical mmethodsethods fforor ttestingesting fforor tthehe eexistencexistence ooff sselectionelection aandnd examiningexamining itsits welfarewelfare consequences.consequences. WWee cconcludeonclude bbyy ddiscussingiscussing ssomeome iimportantmportant iissuesssues thatthat areare notnot well-handledwell-handled byby thisthis fframeworkramework aandnd wwhich,hich, pperhapserhaps relatedly,relatedly, havehave bbeeneen littlelittle addressedaddressed bbyy thethe existingexisting eempiricalmpirical wwork;ork; wwee considerconsider tthesehese ffruitfulruitful aareasreas fforor additionaladditional research.research. OurOur essayessay ddoesoes nnotot aaimim aatt rreviewingeviewing tthehe bburgeoningurgeoning eempiricalmpirical lliteratureiterature oonn sselectionelection iinn iinsur-nsur- aancence mmarkets.arkets. HHowever,owever, aatt rrelevantelevant pointspoints inin ourour discussiondiscussion wewe pointpoint thethe interestedinterested rreadereader ttoo rrecentecent ppapersapers tthathat rrevieweview oorr ssummarizeummarize rrecentecent fi ndings.ndings. AAdversedverse aandnd AAdvantageousdvantageous SSelection:election: A GGraphicalraphical FFrameworkramework TThehe TTextbookextbook EEnvironmentnvironment fforor IInsurancensurance MMarketsarkets WWee sstarttart bbyy consideringconsidering thethe textbooktextbook casecase ofof insuranceinsurance demanddemand andand cost,cost, inin wwhichhich perfectlyperfectly competitive,competitive, risk-neutralrisk-neutral fi rrmsms oofferffer a singlesingle insuranceinsurance contractcontract tthathat ccoversovers somesome probabilisticprobabilistic loss;loss; risk-averserisk-averse individualsindividuals differdiffer onlyonly inin theirtheir ((privately-known)privately-known) probabilityprobability ofof incurringincurring thatthat loss;loss; andand therethere areare nono otherother fric-fric- ttionsions inin pprovidingroviding insurance,insurance, suchsuch asas administrativeadministrative oror claim-processingclaim-processing costs.costs. TThus,hus, mmoreore inin thethe spiritspirit ofof AkerlofAkerlof (1970)(1970) andand unlikeunlike thethe well-knownwell-known environmentenvironment ooff RRothschildothschild andand StiglitzStiglitz (1976),(1976), fi rrmsms competecompete inin pricesprices butbut dodo notnot competecompete oonn tthehe coveragecoverage featuresfeatures ofof thethe insuranceinsurance contract.contract. WeWe returnreturn toto thisthis importantimportant ssimplifyingimplifying assumptionassumption laterlater inin thisthis essay.essay. FFigureigure 1 pprovidesrovides a ggraphicalraphical rrepresentationepresentation ooff tthishis ccasease aandnd iillustratesllustrates tthehe rresultingesulting aadversedverse sselectionelection aass wwellell aass iitsts cconsequencesonsequences fforor iinsurancensurance ccoverageoverage aandnd wwelfare.elfare. TThehe fi ggureure cconsidersonsiders tthehe mmarketarket fforor a sspecifipecifi c iinsurancensurance ccontract.ontract. CConsumersonsumers iinn tthishis mmarketarket mmakeake a bbinaryinary cchoicehoice ooff wwhetherhether oorr nnotot ttoo ppurchaseurchase tthishis ccontract,ontract, aandnd fi rrmsms iinn tthishis mmarketarket ccompeteompete oonlynly ooverver wwhathat ppricerice ttoo cchargeharge fforor tthehe ccontract.ontract. TThehe verticalvertical aaxisxis iindicatesndicates tthehe ppricerice (and(and eexpectedxpected cost)cost) ooff thatthat contract,contract, andand tthehe hhorizontalorizontal aaxisxis iindicatesndicates thethe qquantityuantity ooff iinsurancensurance ddemand.emand. SinceSince individualsindividuals ffaceace a bbinaryinary cchoicehoice ofof wwhetherhether oror notnot toto purchasepurchase thethe contract,contract, thethe “quantity”“quantity” ooff iinsurancensurance iiss tthehe ffractionraction ooff iinsurednsured iindividuals.ndividuals. WWithith rrisk-neutralisk-neutral insuranceinsurance pprovidersroviders aandnd nnoo aadditionaldditional ffrictions,rictions, thethe socialsocial (and(and fi rms’)rms’) costscosts associatedassociated withwith Liran Einav and Amy Finkelstein 117 Figure 1 Adverse Selection