By: Amy Finkelstein
Harvard University and NBER
James Poterba

Theoretical research on insurance markets has long emphasized the potential importance of asymmetric information and documented the negative welfare implications of adverse selection, which can be a consequence of asymmetric information. Yet the empirical evidence on the importance of asymmetric information in insurance markets is decidedly mixed.

Several recent empirical studies have not rejected the null hypothesis of symmetric information in property-casualty, life, and health insurance markets. These studies include Cawley and Philipson (1999), who study the U.S. life insurance market, Cardon and Hendel (2001), who study the U.S. health insurance market, and Chiappori and Salanie (2000), who study the French automobile insurance market.

In contrast, Cutler (2002) reviews a substantial literature that suggests the importance of asymmetric information in health insurance markets, and Cohen (2001) offers some evidence for adverse selection in U.S. automobile insurance markets. These conflicting results raise the question of whether asymmetric information is a practically important feature of insurance markets. This paper tests two simple predictions of asymmetric information models using data from the annuity market in the United Kingdom.

The first is that higher risk individuals self-select into insurance contracts that offer features that, at a given price, are more valuable to them than to lower risk individuals. The second is that the equilibrium pricing of insurance policies reflects variation in the risk pool across different policies. Most empirical research on insurance markets has tested similar predictions using only one feature of the insurance contract: the amount of payment in the event that the insured risk occurs. Our detailed data on annuity contracts allow us to consider adverse selection on many different contract features. Our results, like those in several other studies, suggestlittle evidence of adverse selection on the amount of payment in the event that the insured risk occurs.

However, we find strong evidence of adverse selection along other dimensions of the insurance contract. This underscores the importance of considering multiple features of insurance contracts when testing for adverse selection, since adverse selection may affect not only the quantity of insurance purchased but also the formof the insurance contract. Our results also raise the interesting question of why selection can bedetected on some margins but not on others.

Annuity markets present an appealing setting for studying asymmetric information issues. Most tests for asymmetric information cannot distinguish between adverse selection and moral hazard, even though the welfare and public policy implications of the two are often quite different.

Moral hazard seems likely to play a smaller role in annuity markets, however, than in many other insurance markets. While receipt of an annuity may lead some individuals to devote additional resources to life-extension, we suspect that this is likely to be a quantitatively small effect. If the behavioral effects of annuities are small and the associated moral hazard problems are limited, testing for asymmetric information in the annuity market provides a direct test for adverse selection. Annuity markets are also of substantial interest in their own right.

Mitchell, Poterba, Warshawsky, and Brown (1999) emphasize that annuities, which provide insurance against outliving one’s resources, play a potentially important welfare-improving role for retirees. But in spite of the potential insurance value of annuity products for households that face uncertain mortality risks, voluntary annuity markets in both the United States and the United Kingdom are small.

Adverse selection has often been suggested as a potential explanation for the limited size of these markets, for example by Brugiavini (1993) and others. This paper is divided into five sections. The first describes the general operation of annuity markets, with particular reference to the United Kingdom, and summarizes how the theoretical predictions of asymmetric information models can be tested in annuity markets. Section two describes the data set that we have obtained from a large U.K. insurance company.

The third section reports our findings on the relationship between mortality patterns and annuity product choice, using hazard models to relate annuitant mortality patterns to annuity product characteristics. Section four investigates the pricing of different annuity products, using hedonic models to confirm that annuity pricing isconsistent with our estimates of mortality differences across different annuity policies. The final section summarizes our findings and considers alternative interpretations of the results.